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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                               ----------------

                                   Form 10-K
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
   ACT OF 1934

  For The Fiscal Year Ended September 30, 1999

                         Commission File No. 000-26283
                                      OR

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

                For the transition period from        to

                             DIGITAL ISLAND, INC.
            (Exact name of Registrant as specified in its charter)

               Delaware                             68-0322824
   (State or other jurisdiction of     (I.R.S. Employer Identification No.)
    incorporation of organization)

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

      Registrant's telephone number, including area code: (415) 738-4100
       Securities registered pursuant to Section 12(b) of the Act: None
          Securities registered pursuant to Section 12(g) of the Act:
                        Common Stock, $0.001 par value

   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 past 12 months (or for such shorter period that the Registrant
was required to file such reports, and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [_]

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

   The aggregate market value of voting stock held by non-affiliates of the
Registrant was $1,600,457,643 as of November 29, 1999, based upon the closing
price of the Registrant's Common Stock on the Nasdaq National Market reported
for November 29, 1999. Shares of Common Stock held by each executive officer
and director and by each person who beneficially owns more than 5% of the
outstanding Common Stock have been excluded in that such persons may under
certain circumstances be deemed to be affiliates. This determination of
affiliate status is not necessarily a conclusive determination of affiliate
status for any other purpose.

   35,999,068 shares of the Registrant's $0.001 par value Common Stock were
outstanding at November 29, 1999.

                      DOCUMENTS INCORPORATED BY REFERENCE

   The following documents (or portions thereof) are incorporated by reference
into the Parts of this Form 10-K noted:

   None

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                                     PART I

Item 1. Business

   Except for the historical financial information contained herein, the
matters discussed in this Annual Report on Form 10-K may be considered
"forward-looking" statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Act of
1934, as amended. Such statements include declarations regarding the intent,
beliefs or current expectations of Digital Island and our management. Such
forward-looking statements are not guarantees of future performance and involve
a number of risks and uncertainties. Actual results could differ materially
from those indicated by such forward-looking statements. We undertake no
obligation to publicly release the results of any revision to these forward-
looking statements which may be made to reflect events or circumstances after
the dates hereof or to reflect the occurrence of unanticipated events.
Important factors which could cause actual results to differ materially from
those in the forward-looking statements, include but are not limited to: the
company's short operating history which makes it difficult to predict its
future results of operations; the company's history of operating losses and
expected future losses which could impede its ability to address the risks and
difficulties encountered by companies in new and rapidly evolving markets; the
company's future operating results could fluctuate which may cause volatility
or a decline in the price of the company's stock; and the company may not be
able to price its services above the overall cost of bandwidth causing its
financial results to suffer.

Overview

   We offer a global network and related services for companies that are using
the Internet to deploy key business applications worldwide. Our services make
it easier for companies to globalize their operation and to provide a higher
quality of service and more functions than in the public Internet. We target
corporations that are increasingly relying on the Internet to conduct business
but are constrained by its unreliability, slow performance and limited range of
functions. Our global private network and expert services enable customers to
effectively deploy and manage global applications by combining the reliability,
performance and broad range of functions available in private intranets
operated by individual companies for their own users, with the global access of
the public Internet. We also offer service level guarantees, customized
billing, security services to protect the integrity of data transmissions,
network management and other high quality services designed to improve the
applications deployed on our network. Our customers, which include
multinational corporations such as Autodesk, Cisco Systems, E*TRADE Group and
National Semiconductor, use our services and proprietary technology to
facilitate the deployment of a wide variety of electronic commerce
applications, including online marketing and sales customer service, software,
document and multimedia distribution and online training. As of September 30,
1999, we had contracts with 111 customers, of which 83 were deployed and
generating revenues.

   We developed our global network to help companies globalize their
applications. We operate Web sites and Internet applications, manage computer
servers and maintain networking equipment for our customers in our state-of-
the-art network data centers, and provide network management expertise to our
customers for their own network data centers. The business applications
delivered through our network services are accessed globally in the same way as
any Web site, but with a significant difference: these business applications
are highly available and are designed to operate substantially faster and with
a greater range of functions than sites that rely solely on the public
Internet.

   Our global network consists of a centralized high-speed private network
which acts as a backbone connecting five strategically located data centers in
Hong Kong, Honolulu, London, New York City and Santa Clara, California. This
core network architecture connects over dedicated lines directly to local
Internet service providers in 21 countries. This enables our customers to
transmit Internet traffic seamlessly over our network with dedicated capacity
and to connect directly to international users through local Internet service
providers. We also help our customers distribute content over the Internet by
replicating (mirroring) and storing (caching) their applications in multiple
locations close to their end-users. This allows our customers to benefit from
the

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lower overall cost of data storage versus transport and to provide a better
online experience for their end-users. For example, Digital Island Local
Content Managers enable us to help customers store text, graphics, software,
audio/video streams and other bandwidth intensive files which are repeatedly
accessed in specific geographic regions.

   Our services are designed to allow customers to outsource Internet
activities to us, thereby transferring to us the burden of attracting and
retaining scarce technical staff and adopting continuously changing
technologies, while lowering their operating costs and speeding deployment.

Recent Developments

 Acquisition of Sandpiper Networks

   On October 24, 1999, Digital Island entered into agreement with Sandpiper
Networks, Inc. pursuant to which Digital Island and Sandpiper Networks will
merge. Pursuant to the terms of the merger, Sandpiper's shareholders will
receive 1.0727 shares of Digital Island Common Stock for each shares of
Sandpiper capital stock, or a total of approximately 24.6 million shares of
Digital Island Common Stock. The merger is subject to approval by shareholders
of both parties and regulatory approvals, among other things. Officers,
directors and certain affiliates holding over 76% of the voting power of
Sandpiper Networks and 45% of the voting power of Digital Island have executed
voting agreements in support of the transaction

   Upon completion of the merger, Digital Island's global intelligent network
of five data centers that directly serve 21 countries are expected to be
integrated with Sandpiper Networks' content delivery network consisting of over
1,200 enterprise-class servers to offer Web-based marketing, sales, fulfillment
and support applications worldwide. For a more detailed description of
Sandpiper Networks, see the Registration Statement on Form S-4 relating to the
Sandpiper transaction filed as an exhibit to this Annual Statement.

 Strategic Alliance with SRI International

   Effective November 22, 1999, Digital Island and SRI International, a
California nonprofit public benefit corporation, entered into an agreement
pursuant to which Digital Island will obtain ownership of certain SRI
International proprietary materials. In consideration of this intellectual
property transfer, Digital Island has agreed to pay $6,000,000 to SRI
International. Additionally, pursuant to the agreement, Digital Island has the
option to obtain consulting services from SRI International for an additional
$4,000,000. Payments for the SRI International proprietary materials and the
consulting services shall be made in shares of Digital Island common stock. SRI
International, however, may select to receive up to $1,000,000 of the
$6,000,000 intellectual property purchase payment in cash.

 Strategic Relationship with Sun Microsystems and Inktomi

   On December 7, 1999, Digital Island entered into a memoranda of
understanding with Sun Microsystems, Inc. and Inktomi Corporation providing for
a joint strategic relationship. Under the relationship, Digital Island has
agreed to purchase, over a two year period, up to $150 million of Sun servers,
storage operating systems and server software, using Inktomi network caching
applications. The total purchase would consist of 5,000 Sun servers. Sun and
Inktomi also agreed to participate and invest in joint marketing and sales
activities with Digital Island to support broadband and streaming media content
delivery over the Internet. Sun agreed to provide $100 million of lease
financing for the acquisition of the equipment, consisting of:

  .a $30 million initial line of credit;

  . a $30 million line of credit available in nine months upon meeting
    certain working capital maintenance and financing milestones; and

  . a $40 million line of credit available in fifteen months upon meeting
    certain additional working capital maintenance and financing milestones.

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   For extending this lease financing, Digital Island agreed to grant Sun
warrants to purchase up to $10 million of Digital Island Common Stock in three
tranches corresponding on a pro rata basis with the above three lines of
credit; the warrants will be exercisable at the five-day average trading price
preceding the grant dates, and will expire in 48 months (in the case of the
first warrant) and 36 months (in the case of the second and third warrant). The
lease financing facility and the marketing and sales relationship are subject,
in part, to definitive documentation.

   In connection with the relationship, Sun has agreed to make a $20 million
investment, and Inktomi has agreed to make a $6 million investment, in Digital
Island common stock at a price per share equal to the lesser of the average
closing price of the common stock as quoted on the Nasdaq National Market for
the ten trading days before December 7, 1999 or for the five trading days
before closing of the investment. Sun and Inktomi have agreed to not sell or
otherwise dispose of such shares until the first anniversary of their purchase.
The Sun investment is conditioned, among other things, upon customary
governmental approvals and the Inktomi investment is conditioned upon
consummation of the Sun investment.

Industry Background

   The Internet continues to experience rapid growth and expansion as an
important global medium for communications and electronic business.
International Data Corporation, known as IDC, has estimated that the total
number of Internet users in the world reached approximately 69 million in 1997
and will increase to approximately 319 million in 2002, a 36% compound annual
growth rate. As the numbers of Internet users has grown, enterprises have
increasingly viewed the Internet as an opportunity to interact rapidly with a
larger number of geographically distributed offices, employees, customers,
suppliers and partners. Many enterprises that focus solely on delivering
services over the Internet have emerged as well as offline businesses that have
implemented Internet sites incorporating e-commerce applications. As the
Internet has emerged as a strategic component of business, investment in
Internet services has begun to increase dramatically. According to IDC, the
demand for U.S. Internet and e-commerce services was $2.9 billion in 1997 and
is expected to grow to $22.1 billion by 2002, a 50% compound annual growth
rate.

   Increasing Reliance on Internet Business Applications. As use of the
Internet grows, enterprises are increasing the breadth and depth of their
Internet product and service offerings. Businesses have begun to use the
Internet for an expanding variety of commercial applications, including online
marketing and sales, customer service, software and document and multimedia
distribution, electronic commerce and online training. For many enterprises,
loss of the availability of such business-critical applications often results
in loss of revenue and impairment of customer good will. As a result,
enterprises are increasingly demanding that their networks deliver fast,
consistent, reliable, secure and relevant end user experiences globally, remain
easy to upgrade as the scale and complexity of applications grows and
technologies change, operate continuously 24 hours per day, seven days per
week, and offer the applications support and functionality (e.g. security, user
location, identification and usage patterns) previously provided only in
private corporate wide area networks.

   Inherent Problems with the Internet/Need for a Robust Global Solution. The
public Internet infrastructure was designed for applications requiring limited
communications bandwidth capacity and was not designed with the quality
necessary for core business uses such as electronic commerce. For enterprises
requiring global solutions, the U.S.-centric nature of the public Internet
results in poor response times, particularly for applications requiring large
file transfers, instantaneous interaction between networked users and overseas
transport. This occurs because data transmittal between countries must travel
through telecommunications lines in the U.S. where the Internet originated and
where most of its infrastructure is still located, and make a large number of
connections through various regional and national Internet service providers
before reaching its destination. Data packets often become lost in the transfer
process, especially for data-intensive transfers involving large software
downloads, multimedia document distribution and audio or video content. The
response time for users is also often slow.


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   Trend Toward Outsourcing of Internet Operations. In seeking to address the
performance issues of the public Internet, enterprises have increasingly found
that investing in the resources and personnel required to
maintain in-house private networks is cost-prohibitive and extremely difficult
given the shortage of technical talent and risk of technological obsolescence.
With the failure of in-house solutions to address their needs, today's
enterprises have increasingly sought third party providers to support their
Internet applications deployment, operations and ongoing maintenance. Regional
and national Internet service providers, however, often fail to provide an
adequate solution because they lack the geographically distributed network
capability necessary to deliver content globally using replication and caching
technologies, which are becoming increasingly important as the Internet usage
and bandwidth demand increase. IDC estimates that corporate spending on web
hosting services will increase from approximately $414 million in 1997 to $11.8
billion by 2002, a 95% compound annual growth rate. Enterprises are
increasingly seeking companies that combine intelligent networking, regional
hosting services and geographically dispersed content distribution to deploy
the enterprise's applications closer to the end-user.

The Digital Island Solution

   We offer a global private network and related services for companies that
need worldwide deployment of key business applications over the Internet. Our
solution provides the following key advantages:

   Global Connectivity and Availability. The Digital Island Global IP
Applications Network currently has connection point in 21 countries in Asia,
Europe, North America, South America and Australia. We believe that this global
reach provides our customers with local access to the majority of existing
Internet users.

   High Performance and Scalability. The Digital Island Global IP Applications
Network bypasses the primary congestion points of the public Internet to
provide fast, consistent performance for our customers. By routing and managing
Internet traffic over a centralized high-speed network directly between our
strategic, globally distributed data centers and local points of presence, our
solution avoids transmission of data over multiple routers and switches
(systems that relay data in networks) and network access points (locations at
which Internet service providers exchange traffic) in the public Internet,
thereby substantially reducing transmission time and improving network security
and performance. Our network architecture is reliable, can scale to many users
and enables a consistent end user experience independent of time of day and
geography.

   Local Content Management. We own and operate a growing number of Digital
Island Local Content Managers in high volume markets around the world. We have
created "digital warehouses" where we help customers readily store text,
graphics, software, audio/video and other bandwidth intensive files which are
repeatedly accessed within the regional area. This solution is a more cost
effective and scalable solution when supporting high volume global access to
information. It also allows for a more geographically localized experience
(e.g. language and currency). We currently operate Digital Island Local Content
Manager sites in Brazil, Germany, Japan, Singapore, the Netherlands, Hong Kong,
France, Australia, South Africa, the U.S., and the United Kingdom and plan to
continue our current expansion program.

   Cost-Effective Outsourcing Solution. Our customers directly benefit from the
significant investments of technical expertise and other resources that we have
made to develop our unique Digital Island Global IP Applications Network. Most
enterprises today do not have the infrastructure that mission-critical Internet
operations require, including strategic, globally distributed data centers, 24
hours per day, seven days per week operations and specialized Internet
technology expertise. Our solution allows customers to address shortages of
technical resources and continuously changing technologies, while substantially
lowering the application deployment and operational costs of new Internet
applications. We believe that our solutions and economies of scale are
significantly more cost-effective than most in-house alternatives.

   Innovative Solutions. We believe that, as a result of our advanced network
architecture and highly experienced product development team, we are able to
provide a unique set of value-added product offerings. For example, we offer
open, reserved and managed bandwidth products that enable our customers to
allocate

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their bandwidth purchases according to their changing needs. In addition, our
proprietary technology enables us to bill our customers according to the number
of bits of data transmitted over our network, geographic destination of
transmission and time of day, as opposed to traditional flat-rate billing. This
allows us to provide more flexible service pricing, and benefits the customer
by more accurately correlating network cost to actual network utilization by
geography. TraceWare(TM) technology is a geographic atlas of the Internet. This
software maps an Internet address to a country where the user resides in with
over 90% accuracy. Customers are currently using TraceWare for a range of
applications. For example, Financial Times uses TraceWare to target ad banner
services specifically to different geographic regions. Digital River adopted
TraceWare in its fraud detection algorithms which help it reduce losses from
credit card by detecting the country where the user is accessing the system and
matching this information against known credit card history and user address.
TraceWare also has applications in helping to create flexible pricing plans,
localization of content and currency, assistance in fraud detection,
authentication and compliance with export regulations and the enhancement of
other applications deployed across our network.

Business Strategy

   Our objective is to be the leader in offering network services for
globalizing Internet business applications. In order to achieve this objective,
we are implementing a business strategy focused on the following key elements:

   Target Multinational Corporations. We have designed our network to address
the sophisticated needs of multinational customers, who are increasingly
relying on the Internet to conduct business and require consistent levels of
high performance and reliability. We primarily target leading customers in
industries which are early adopters of Internet technologies, such as the
financial services, technology, media publishing, entertainment and other
Internet-centric sectors. We have tailored our services to enhance the
performance of our customers in electronic commerce and services, such as
digital media distribution. The Digital Island Global IP Applications Network
has connection points in 21 countries worldwide, providing our customers with
access to a significant majority of existing Internet users, and we plan to
expand our global reach through additional connection points in the future.

   Expand Customer Relationships. We plan to extend our leadership in the
market for global Internet application services by continuing to expand our
base of customers. By integrating other Internet services into the Digital
Island Global IP Applications Network, and by providing high-quality customer
support, we believe that businesses will increasingly rely on us for their
Internet business needs, which in turn should enhance customer retention and
increase demand for both application services and network usage. For example,
Autodesk initially used our network to deploy applications in a single country;
subsequently, Autodesk chose to deploy applications in other countries served
by Digital Island and added additional applications and extended usage of our
services to key subsidiaries.

   Develop Additional Network Services. We seek to be a leader in designing and
deploying a global business network that enables customers to capture the
benefits of ubiquitous access to applications and the performance and range of
functions of private intranets operated by individual companies for their own
users. We are committed to investing resources to implement new Internet
technology and services that will allow our customers to optimize their
deployment and operation of applications globally. To this end, we collaborate
with providers of leading Internet technologies to develop and deploy
proprietary technologies in order to enhance our service offerings and to
address our customers' evolving needs. Some of our innovations have included
reserved and managed bandwidth technologies that allow customers to tailor
bandwidth to their individual needs and benefit from usage-based billing, and
our TraceWare technology that enables customers to identify the source of
Internet traffic. The Digital Island Local Content Managers enable customers to
readily store files which are repeatedly accessed within specific geographical
regions. We believe that continuing leading edge innovation is the key to
differentiating Digital Island's products and services in the long term.

   Expand Strategic Relationships. We believe that strategic relationships
should enhance our ability to reach new customers. Potential partners include
system integrators, software vendors and application service

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providers that provide network equipment and services to companies. Further,
strategic relationships with our customers in our target markets, such as with
E*TRADE, bring not only a high level of understanding of the specific needs of
that market but also credibility and visibility with potential new customers.
We are also targeting partners which can enhance our ability to develop and
deliver new application services. Through these relationships we hope to
leverage these enterprises' research and development expertise to cost
effectively develop new network services.

   Expand Global Sales Capabilities. We target our customers predominately
through a direct sales channel complimented by a range of external alliances
and channels. We currently have 79 professionals in our sales organization in
offices in the U.S., Asia and Europe and intend to grow our sales organization
substantially over the next year. Our Global Partner Program is targeted at
increasing the effectiveness of our direct channel. In addition to co-
marketing, we have a growing number of sales channel partners which represent
our products and services either as a sales agent or a reseller.

Network Architecture

   The Digital Island Intelligent Network consists of an asynchronous transfer
mode, or ATM, backbone that connects five geographically dispersed data
centers. This ATM backbone router core is a centralized high-speed network that
connects to local Internet service providers in 21 countries forming a
distributed network architecture that minimizes the number of separate
transmissions, necessary to transmit data, resulting in greater speed and
reliability for our customers' end-users. Our five distributed data centers
permit us to disseminate information reliably on a global basis and, using our
sophisticated data tracking capability, allows us to optimize data
transmissions internationally, minimizing the use of expensive transoceanic
fiber optic circuits. The Digital Island network is designed to increase the
speed and reliability of data transmission and circumvents a design weakness of
the public Internet, which requires transmission of information over numerous
routers and network inter-exchange points, often leading to delays and loss of
data. Local Content Managers, where customers can store files which are
repeatedly accessed within the regional area, are located in Brazil, Singapore,
the Netherlands, Hong Kong, France, Australia, Japan, Germany, South Africa,
the United Kingdom and all three U.S. data centers. We believe our architecture
is superior to traditional networks for the distribution of applications
because of its manageability, ability to scale to many users and connectivity
over dedicated lines to local Internet service providers and network service
providers through dedicated connection points.

   We currently have direct connections in 21 countries with one or more local
Internet service providers, providing customers with direct access to local
markets worldwide. Currently, we purchase transit from AT&T, GTE, Sprint and
MCI WorldCom in the United States and have established transport relationships
in 7 other countries, giving us a total of 28 different direct points of
connection to the Internet. Unlike traditional peering relationships, these
network service providers carry the Internet traffic of our customers without
any reciprocal transit agreement. While we pay a fee to the network service
providers for this arrangement, it gives us access to thousands of Internet
service providers without the obligation of carrying traffic originating
outside of our network. Both the Santa Clara and New York data centers have
direct connections through circuits with each of the four network service
providers. In addition to the U.S., we have established private Internet
connection relationships in 20 other countries as listed below:

                Australia            Israel       South Korea
                  Brazil             Japan           Sweden
                  Canada             Mexico       Switzerland
                  China           Netherlands        Taiwan
                  France             Russia      United Kingdom
                 Germany           Singapore         Italy
                  Spain           South Africa

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   In China, we have connections in both Hong Kong and Beijing. With 28
different connection points to the Internet, we believe we offer our customers
one of the most diverse, redundant and reliable networks for the deployment of
business applications globally.
   We currently have state-of-the-art network operations centers in Honolulu,
Hawaii and London, UK. Each center provides real time end-to-end monitoring of
our network 24 hours per day, seven days a week, 365 days per year and operate
as fully redundant network operation sites. The network operations center helps
us to ensure the efficient and reliable performance of our network, enabling us
to identify, and often prevent, potential network disruptions and to respond
immediately to actual disruptions. In addition, through traffic management and
forecasting, line performance reporting and alarm monitoring, remote link
restoration and coordination, and provisioning of network services, the network
operations center enables us to schedule and conduct maintenance with minimal
interferences to the network. In addition to the two network operations
centers, we maintain a Level 2 Support Center located in San Francisco. Level 2
Support acts as an escalation point for each of the primary network operations
centers as well as a third redundant location capable of managing the worldwide
network.
   We currently lease lines or bandwidth from multiple telecommunications
carriers. These carriers include MCI WorldCom, GTE and Sprint, as well as
several international carriers such as Cable & Wireless, IDC, Telstra and
Singapore Telecom. Leasing from multiple carriers assists us in achieving
competitive pricing, provides us with diversity of routes and redundancy and
provides access to multiple sources of bandwidth on different cable systems
globally. Our lease contract term with a carrier is typically one year, which
allows us to benefit from declining bandwidth costs over time. In some cases
the term may extend to three years where we determine there is a significant
cost advantage implicit in such arrangement or that the route served by such
line is bandwidth constrained.

Services

   We offer a family of services designed to allow companies to deploy their
Internet applications globally without developing or acquiring their own global
network hosting centers or content management capability. Our services are
especially suited to Internet applications requiring a high performance end
user experience which is consistent and reliable when downloading files (e.g.,
software, documentation and video clips), downloading graphic-intensive web
content or engaging in real-time transactions (e.g., transaction clearing and
video conferencing) across a range of access speeds. We work with each of our
customers to optimize cost and performance requirements. Our content hosting,
mirroring and caching services allow customer applications to be replicated
throughout the network to lower costs and improve response times and our
transport services guarantee bandwidth into local markets. Our network
engineering team provides our customers with global networking expertise and
consultation in the design and deployment of their applications on the Digital
Island Global IP Applications Network. We also provide 24 hours per day, seven
days per week, 365 days per year operations support and security experts to
keep their applications up and running on a global basis.

   We currently offer service level guarantees, customized billing, network
security services, network management and other application services designed
to improve the performance of applications deployed on our network. We plan to
continue to develop or acquire extensions to our application services to fuel
ongoing product and service delivery. For example, we believe that our
proprietary TraceWare technology, which is not yet commercially released,
enables our customers to identify the source of Internet protocol requests as
well as the destinations of Internet traffic. This technology will be
predominantly used for targeted advertising and local language content
delivery.

 Application Hosting and Content Distribution Services

   Our application hosting and content distribution services, including
mirroring and caching, enable customers to gain the benefit of having their
application (whether on a server on their site or on a server in one

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of our data centers) appear to be located in every country where it has a
connection point. Leveraging our network architecture and technologies, our
application hosting services provide end users globally with what we believe,
based on our past experience, to be fast, reliable and seamless access to our
customers' content. Each of our data centers has state-of-the-art power
management, security, and fire suppression systems. Customers have access to
our network operations center and our on-site personnel for ongoing maintenance
services. Customers can choose from the following packages:

   Server Management Package. This is an all-inclusive solution for customers
seeking to outsource their day-to-day hardware and server administration. We
operate two production-ready environments: Sun Solaris(TM) and Windows NTTM
operating on Compaq servers. We host these servers, as well as servers provided
by our customers, in our data centers and provide the network infrastructure as
well as application monitoring, performance optimization, server administration
and security services. This package provides a production-ready environment
with maximum uptime.

   Hardware Management Package. This enables our customers to outsource day-to-
day hardware maintenance, while allowing our customers' IT staff unhindered
access to perform any needed system administration functions. This package
includes services from our data center personnel for hardware management and
repair plus access to our network infrastructure. Our centrally managed network
architecture provides optimized routing, resulting in the uptime, performance,
and reliability required by our customers.

   Co-location Package. This allows our customers to house their own servers in
one of our data centers, and provides a secure environment designed to deliver
maximum uptime for the server plus access to our Global IP Applications
Network.

   Globeport. For customers choosing to maintain content at their own data
centers, we will arrange dedicated connections from the client's site to our
closest point of presence. This package includes network services enabling our
customers to extend their reach globally.

 Network Services

   We offer a range of network services to be used with our Application Hosting
and Content Distribution Services:

   Open Bandwidth. Customers pay a minimum monthly fee for access to our
network and are charged based on actual usage (per gigabit) above these minimum
levels. Customers may also pay for services based on distance traveled.
Customers can generate utilization reports which allow them to determine usage
flows by country.

   Reserved Bandwidth. Reserved Bandwidth is a network service that guarantees
a minimum throughput level, expressed in kilobytes per second to a specified
connection point. Our customer is billed for a pre-specified minimum amount of
data transfer to that specified connection point. Unlike other methods of
relaying Internet traffic such as frame relay services, our network is
engineered to accommodate peaks in traffic above the minimum guaranteed levels.
Gigabytes in excess of the reserved monthly amount are billed at the applicable
data transfer rate.

   Managed Bandwidth. Managed Bandwidth is our premium network transport
service offering. Using a web browser interface, IT professionals can readily
allocate bandwidth by geographic region at any time from any location. Through
this service, IT professionals can configure the Digital Island network to meet
their organization's international throughput requirements.

   Streaming Services. We offer a full range of encoding and streaming services
targeted for on demand audio and video delivery of audio/video content. Through
a strategic partnership with RealNetworks and Inktomi, we have deployed a
global streaming network fully capable of delivering audio/video streams in
over 10 countries. Backed by unmatched service level agreements, this service
will continue to be expanded through the support of additional media formats
and geographies.

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 Professional Services

   We augment our primary product and service offerings with a range of
professional service options for customers. Professional services include
helping our customers to provide security on their networks, making
recommendations for network equipment and consulting as to Internet application
deployment.

Customers

   We primarily target leading customers in industries which are early adopters
of Internet technologies, such as the financial services, technology, media and
other Internet-centric sectors. Within our target markets, we have tailored our
services to enhance the performance of our customers in electronic commerce,
electronic services and electronic fulfillment, such as digital media
distribution. Our customers use our services and proprietary technology to
facilitate the deployment of commercial applications, including electronic
commerce, online customer service, software distribution, multimedia document
distribution, sales management and distance learning. As of September 30, 1999,
we had contracts with 111 customers including Autodesk, Cisco Systems, E*TRADE,
Mastercard International, National Semiconductor and Novell.

Sales and Marketing

   Our sales and marketing strategy is designed to target multinational
businesses that depend on the Internet for core business operations.

   To reach these enterprises, we utilize a multi-tiered channel approach. In
North America, we primarily rely on direct sales and augments this effort with
resellers, agents or co-marketing partners where appropriate. In Europe, Asia
and Latin America, we are hiring direct sales personnel and developing agents
and reseller channels. Our channel partners also provide services to us in the
form of connectivity to local backbones or service providers and router
installation/repair.

   We are actively seeking to increase our sales and distribution capabilities
globally. Currently, most of our sales are derived from the efforts of our
direct sales force. We have begun developing indirect sales channels targeting
content developers (such as firms that develop web sites), system integrators,
consulting companies, suppliers and international Internet service providers.
As of September 30, 1999, we had five channel partners in Europe and Asia to
whom we pay commissions to refer customers.

   Our marketing organization is responsible for product management, product
marketing, public relations and marketing communications. Product management
includes defining the product plan and bringing to market our products and
services. These activities include product strategy and definition, pricing,
competitive analysis, product launches, channel program development and product
life cycle management. We stimulate product demand through a broad range of
marketing communications and public relations activities. Primary marketing
communications activities include public relations, collateral, advertising,
direct response programs and management of our web site. Our public relations
focuses on cultivating industry analyst and media relationships with the goal
of securing broad media coverage and recognition as a leader and innovator in
global Internet application deployment.

   While we have not entered into any material partnering arrangements, a key
element of our marketing strategy includes identifying and partnering with
component suppliers, customers and other application service companies. We have
a dedicated team focused on creating new, and expanding existing, relationships
which will be critical to the ongoing success of future product developments.

Customer Support

   We seek to provide superior customer service by understanding the technical
requirements and business objectives of our customers and fulfilling their
needs proactively on an individual basis. By working closely with the customer,
we seek to optimize the performance of our customers' Internet operations,
avoid downtime, resolve quickly any problems that may arise and make
adjustments in services as customer needs change over time.

                                       10
<PAGE>

   Before sales are made, we provide technical advice to customers in order to
help them understand their Internet applications related needs and how our
products and services can provide solutions for particular needs. During the
installation phase, we assign a support team led by our Customer Advocacy group
which also retains support responsibility for the account after the customer's
application is installed and operational, to assist the customer through the
installation process. After commencing services, primary technical support is
provided by our network operation centers, which are operated 24 hours per day,
seven days per week by highly trained technicians who respond to customer
calls, monitor site and network operations and escalate problems to engineering
to solve problems quickly and professionally. Our Customer Advocacy personnel
are also available to assist with billing and business issues and to assist in
planning for additional customer applications usage on the network.

   Finally we employ network engineers who collaborate with customers to design
and maintain their application across the network. Our network engineers are
trained on Windows NT, Solaris and other UNIX platforms, as well as Cisco
routers and switches, and they serve as the escalation path to resolve customer
problems. We also employ a team of network backbone engineers that constantly
monitor the network design and effectiveness to optimize performance for
customers, rerouting and redesigning their applications as conditions require.

Competition

   Our market is highly competitive. There are few substantial barriers to
entry and we expect that we will face additional competition from existing
competitors and new market entrants in the future. The principal competitive
factors in this market include Internet system engineering expertise, customer
service, network capability, reliability, quality of service and ability to
scale to many users, broad geographic presence, brand name recognition,
technical expertise and range of functions, the variety of services offered,
the ability to maintain and expand distribution channels, price, the timing of
introductions of new services, network security, financial resources and
conformity with industry standards. We may not have the resources or expertise
to compete successfully in the future.

   Our current and potential competitors in the market include:

  . information technology and Internet outsourcing firms;

  . national and regional Internet service providers; and

  . global, regional and local telecommunications companies.

   Our competitors may operate in one or more of these areas and include
companies such as AboveNet Communications, Inc., AT&T Corp., Exodus
Communications, Inc., GTE Corporation, MCI WorldCom, Inc. and business units of
Frontier GlobalCenter, Inc. In particular, Exodus and GlobalCenter provide
services that are directly competitive with services that we provide.

   Many of our competitors have substantially greater financial, technical and
marketing resources, larger customer bases, longer operating histories, greater
name recognition and more established relationships in the industry than we do.
As a result, these competitors may be able to develop and expand their network
infrastructures and service offerings more quickly, adapt to new or emerging
technologies and changes in customer requirements more quickly, take advantage
of acquisition and other opportunities more readily, devote greater resources
to the marketing and sale of their products and adopt more aggressive pricing
policies than it can. In addition, these competitors have entered and will
likely continue to enter into joint ventures or consortiums to provide
additional services competitive with those that we provide.

                                       11
<PAGE>

   Some of our competitors may be able to provide customers with additional
benefits in connection with their Internet system and global applications
network solutions, including reduced communications costs, which could reduce
the overall costs of their services relative to the cost of our services. We
may not be able to offset the effects of any such price reductions. In
addition, we believe that the businesses in which we compete are likely to
encounter consolidation in the near future, which could result in increased
price and other competition that could cause our business and prospects to
suffer.

Intellectual Property Rights

   We rely on a combination of copyright, trademark, service mark and trade
secret laws and contractual restrictions to establish and protect proprietary
rights in our products and services. Although we have filed a patent
application with respect to our TraceWare technology with the United States
Patent and Trademark Office, such application is pending and we currently have
no patented technology that would preclude or inhibit competitors from entering
our market. In addition, we have registered the mark "Digital Island" with the
Patent and Trademark Office, and we have a pending trademark application for
the mark "TraceWare" with the Patent and Trademark Office. Our "Digital Island"
mark is either registered or pending in several foreign countries. We have
entered into confidentiality and invention assignment agreements with our
employees, and nondisclosure agreements with our suppliers, distributors and
appropriate customers in order to limit access to and disclosure of our
proprietary information. These contractual arrangements or the other steps that
we take to protect our intellectual property may not be sufficient to prevent
misappropriation of our technology or to deter independent third-party
development of similar technologies. The laws of foreign countries may not
protect our products, services or intellectual property rights to the same
extent as do the laws of the United States.

   To date, we have not been notified that our products infringe the
proprietary rights of third parties, but third parties may in the future claim
that our current or future products infringe upon their proprietary rights. We
expect that participants in our markets will be increasingly subject to
infringement claims as the number of products and competitors in our industry
segment grows. Any such claim, whether meritorious or not, could be time
consuming, result in costly litigation, cause product installation delays or
require us to enter into royalty or licensing agreements. Such royalty or
licensing agreements might not be available on terms acceptable to us, or at
all. As a result, any such claim could harm our business and prospects.

Government Regulation

   Federal Regulation. The FCC does not currently regulate network software or
computer equipment-related services that transport data or voice messages on
telecommunications facilities, except when provided by any of the Regional Bell
Operating Companies. However, we provide network services including
transmitting data over public telephone lines, and those transmissions are
governed to some extent by federal regulatory policies establishing charges and
terms for wireline communications. Operators of those types of networks that
provide access to regulated transmission facilities only as part of a data
services package currently are not subject to direct regulation as
"telecommunications carriers" by the FCC or any other federal agency, other
than regulations generally applicable to businesses.

   The absence of direct FCC regulation reflects, in part, the status of
Internet services as a relatively recent phenomenon. The federal legal and
regulatory framework for such services is therefore in its nascent state of
development.

   The evolving state of federal law and regulation is reflected in the FCC's
April 10, 1998 Report to Congress. In the April 1998 Report, the FCC discussed
whether Internet service providers should be classified as telecommunications
carriers, and, on that basis, be required to contribute to the Universal
Service Fund which was created by federal statute and funded by interstate
telecommunications carriers for the purpose of ensuring that all segments of
the population of the United States have access to basic telecommunications
services. The report concluded that Internet access service which the FCC
defined as an offering combining computer processing, information storage,
protocol conversion, and routing transmissions is an "information service"
under the Telecommunications Act of 1996 and thus not subject to regulation. In
contrast, the FCC found that the provision of transmission capabilities to
Internet service providers and other information service

                                       12
<PAGE>

providers does constitute "telecommunications services" under the
Telecommunications Act of 1996. Consequently, parties providing those latter
services are presently subject to FCC regulation (and the corresponding
Universal Service Fund obligations).

   New federal laws and regulations may be adopted in the future that would
subject the provision of our Internet services to government regulation.
Legislative initiatives currently being considered in Congress, for example,
may require taxation of Internet-related services like those that we offer or
impose access charges on Internet service providers. Any new laws regarding the
Internet, particularly those that impose regulatory or financial burdens, could
cause our business and prospects to suffer. We cannot predict the impact, if
any, that any future changes in law or regulation may have on our business.

   Certain changes in federal law and regulations could cause our business and
prospects to suffer. Changes of particular concern include those that directly
or indirectly affect the regulatory status of Internet services, increase the
cost telecommunications services (including the application of access charges
or Universal Service Fund contribution obligations to Internet services), or
increase the competition from the RBOCs and other telecommunications companies.
We cannot predict the impact, if any, that such legislative or regulatory
changes may have on our business. For instance, the FCC could determine through
any one of its ongoing or future proceedings that the Internet is subject to
regulation. In that event, we could be required to comply with:

  . FCC entry or exit regulations;

  . tariff filing, reporting, fee, and record-keeping requirements;

  . marketing restrictions;

  . access charge obligations; and

  . contributions to the Universal Service Fund obligations.

   Any one or more of those changes could adversely impact our ability to
provide services. The FCC could similarly conclude that providing Internet
transport or telephony services over an Internet protocol-based network is
subject to regulation. For example, the FCC currently has ongoing proceedings
in which it is considering whether to regulate certain transmissions provided
via the Internet, such as services functionally equivalent to traditional two-
way voice telephony. Such determination could cause our business and prospects
to suffer.

   Another major and unresolved regulatory issue concerns the obligation of
information service providers, including Internet service providers, to pay
access charges to Incumbent Local Exchange Carriers. A proceeding initiated by
the FCC in December 1996 that raises the issue whether Incumbent Local Exchange
Carriers, which are local telephone companies that began providing service
prior to the enactment of the Telecommunications Act of 1996, can assess
interstate access charges on information service providers, including Internet
service providers. Unlike basic services, enhanced services, which the FCC has
concluded are synonymous with information services and include Internet access
services, are exempt from interstate access charges. The FCC has reaffirmed
that information service providers are exempt from access charges, and a United
States Court of Appeals has affirmed this decision by the FCC.

   Another major regulatory issue concerns Internet-based telephony. In its
April 1998 Report, the FCC observed that Internet protocol telephony appears to
be a telecommunications service rather than an unregulated information service.
The FCC explained that it would determine on a case-by-case basis whether to
regulate the service and thereby require providers of Internet protocol
telephony to contribute to the Universal Service Fund. The ultimate resolution
of Internet protocol telephony issues could negatively impact the regulatory
status, cost and other aspects of our service offerings.

   Another major and unresolved regulatory proceeding that could affect the
benefit and cost of our service offerings (to the extent we become involved in
the exchange of communications traffic) involves reciprocal

                                       13
<PAGE>

compensation. Reciprocal compensation relates to the fees paid by one carrier
to terminate traffic on another carrier's network. In July 1997, the FCC was
asked to determine whether Competitive Local Exchange Carriers (local telephone
companies that provide service in competition with Incumbent Local Exchange
Carriers) that serve Internet service providers are entitled to reciprocal
compensation under the Telecommunications Act of 1996 for calls originated by
customers of an Incumbent Local Exchange Carriers to an Internet service
provider served by a Competitive Local Exchange Carriers within the same local
calling area. Prior to the time the FCC addressed the issue, every state that
addressed the issue from an intrastate perspective (at least 29 in number)
determined that calls to Internet service providers are to be treated as local
for purposes of reciprocal compensation. In February 1999, the FCC concluded
that it would regulate in the future calls to Internet service providers as
interstate traffic. The FCC sought comment on how this traffic should be
compensated prospectively between carriers. The FCC's ultimate resolution of
the compensation issue could increase Internet service provider costs in the
future by increasing telephone charges if the FCC adopts a rule that precludes
compensation for calls to Internet service providers or prescribes a rate that
is substantially less than the reciprocal compensation rates that were paid in
the past and are being paid under some existing inter-carrier agreements.

   We could also be harmed by federal (as well as state) laws and regulations
relating to the liability of on-line services companies and Internet access
providers for information carried on or disseminated through their networks.
Several private lawsuits seeking to impose such liability upon on-line services
companies and Internet access providers are currently pending. In addition,
legislation has been enacted and new legislation has imposed liability for the
transmission of, or prohibits the transmission of certain types of, information
on the Internet, including sexually explicit and gambling information. The
United States Supreme Court has already held unconstitutional certain sections
of the Communications Decency Act of 1996 that, among other provisions,
proposed to impose criminal penalties on anyone distributing "indecent"
material to minors over the Internet. Congress subsequently enacted legislation
that imposes both criminal and civil penalties on persons who knowingly or
intentionally make available materials through the Internet that are "harmful"
to minors. However, the new law generally excludes from the definition of
"person" Internet service providers that are not involved in the selection of
content disseminated through their networks. Congress also enacted legislation
recently that limits liability for online copyright infringement. That latter
law includes exemptions which enable Internet service providers to avoid
copyright infringement if they merely transmit material produced and requested
by others. It is possible that other laws and regulations could be enacted in
the future that would place copyright infringement liability more directly on
Internet service providers. The imposition of potential liability on us and
other Internet access providers for information carried on or disseminated
through their systems could require us to implement measures to reduce our
exposure to such liability, which may in turn require us to expend substantial
resources or to discontinue service or product offerings. The increased
attention to liability issues as a result of lawsuits and legislative action,
could similarly impact the growth of Internet use. While we carry professional
liability insurance, such insurance may not be adequate to compensate claimants
or may not cover us in the event we become liable for information carried on or
disseminated through our networks. Any costs not covered by insurance incurred
as a result of such liability or asserted liability could cause our business
and prospects to suffer.

   State Regulation. The proliferation of Internet use in the past several
years has prompted state legislators and regulators to consider the adoption of
laws and regulations to govern Internet usage. Much of the legislation that has
been proposed to date may, if enacted, handicap further growth in the use of
the Internet. It is possible that state legislatures and regulators will
attempt to regulate the Internet in the future, either by regulating
transactions or by restricting the content of the available information and
services. While state public utility commissions generally have declined to
directly regulate enhanced or information services, some states have continued
to regulate particular aspects of enhanced services in limited circumstances,
such as where they are provided by local telecommunications carriers. Moreover,
the public utility commissions of several states continue to consider potential
regulation of such service. Enactment of such legislation or adoption of such
regulations could cause our business and prospects to suffer.


                                       14
<PAGE>

   Another area of adverse potential state regulation concerns taxes. The
United States Congress recently enacted a three-year moratorium on new state
and local taxes on the Internet (those not generally imposed or actually
enforced prior to October 1, 1998) as well as on taxes that discriminate
against commerce through the Internet. Congress also established an advisory
commission to study and make recommendations on the federal, state and local
taxation of Internet-related commerce. These recommendations are due to
Congress by April 2000 and could serve as the basis for additional legislation.
Previous to the enactment of the tax moratorium a significant number of bills
had been introduced in state legislatures that would have taxed commercial
transactions on the Internet. Future laws or regulatory changes that lead to
state taxation of Internet transactions could cause our business and prospects
to suffer.

   One issue of growing importance revolves around contract law. Although
customer-level use of the Internet to conduct commercial transactions is still
in its infancy, a growing number of corporate entities are engaging in Internet
transactions. This Internet commerce has spawned a number of state legal and
regulatory issues, such as whether and how provisions of the Uniform Commercial
Code (adopted by 49 states) apply to transactions carried out on the Internet
and how to decide which jurisdiction's laws are to be applied to a particular
transaction. It is not possible to predict how state law will evolve to address
new transactional circumstances created by Internet commerce or whether the
evolution of such laws will cause our business and prospects to suffer.

   State legislators and regulators have also sought to restrict the transition
or limit access to certain materials on the Internet. For example, in the past
several years, various state legislators have sought to limit or prohibit:

  . certain communications between adults and minors;

  . anonymous and pseudonymous use of the Internet;

  . on-line gambling; and

  . the offering of securities on the Internet.

   Enforcement of such limitations or prohibitions in some states could affect
transmission in other states. State laws and regulations that restrict access
to such materials on the Internet could inadvertently block access to other
permissible sites. We cannot predict the impact, if any, that any future laws
or regulatory changes in this area may have on our business.

   Some states have also sought to impose tort liability or criminal penalties
on certain conduct involving the Internet, such as the use of "hate" speech,
invasion of privacy, and fraud. The adoption of such laws could adversely
impact the transmission of non-offensive material on the Internet and, to that
extent, could cause our business and prospects to suffer.

   Local Regulation. Although local jurisdictions generally have not sought to
regulate the Internet and related services, it is possible that such
jurisdictions will seek to impose regulations in the future. In particular,
local jurisdictions may attempt to tax various aspects of Internet access or
services, such as transactions handled through the Internet or subscriber
access, as a way of generating municipal revenue. The imposition of local taxes
and other regulatory burdens by local jurisdictions could cause our business
and prospects to suffer. Our networks may also be subject to numerous local
regulations such as building codes and licensing. Such regulations vary on a
city by city and county by county basis.

   Foreign Regulation. As our services becomes available over the Internet in
foreign countries, and as we facilitate sales by our customers to end users
located in such foreign countries, these foreign jurisdictions may decide that
we are required to qualify to do business in the particular foreign country or
to obtain permits or licenses to provide permits or licenses to provide value-
added network services. Such decisions could subject us to taxes and other
costs and could result in our inability to enforce contracts in such
jurisdictions. It is possible that claims could be made against online service
companies and Internet service providers under foreign law for defamation,
negligence, copyright or trademark infringement, or other theories based on the

                                       15
<PAGE>

nature and content of the materials disseminated through their networks. Any
such new legislation or regulation, or the application of laws or regulations
from jurisdictions whose laws do not currently apply to our business, could
cause our business and prospects to suffer.

Employees

   As of September 30, 1999, we had 267 employees, including 117 people in
sales and marketing, 56 people in engineering, 68 people in operations and 26
people in finance and administration. We believe that our future success will
depend in part on our continued ability to attract, hire and retain qualified
personnel. The competition for such personnel is intense, and there can be no
assurance that we will be able to identify, attract and retain such personnel
in the future. None of our employees is represented by a labor union, and
management believes that our employee relations are good.

Item 2. Properties

   We currently have the following facilities: our corporate headquarters in
San Francisco, and data centers in Honolulu, Santa Clara (California), New York
City, Hong Kong, and London. In addition, we have sales offices in Boston, New
York City, Minneapolis, Chicago, Philadelphia, Dallas, Houston, St. Louis,
Atlanta, Reston (Virginia), Japan, Malaysia, the Netherlands, Switzerland and
the United Kingdom.

Item 3. Legal Proceedings

   We are not a party to any material legal proceeding.

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

   None.

                                       16
<PAGE>

                                    PART II

Item 5. Market for the Registrant's Common Stock and Related Stockholder
Matters

   We have paid not cash dividends on our common stock since our incorporation
and anticipate that for the foreseeable future, we will continue to retain any
earnings for use in our business.

   Our common stock has traded on the Nasdaq National Market under the symbol
"ISLD" since June 29, 1999. The following table sets forth the range of high
and low sales prices reported on the Nasdaq National Market for our common
stock for the periods indicated.

<TABLE>
<CAPTION>
                                                                  High    Low
                                                                 ------- ------
     <S>                                                         <C>     <C>
     Fiscal 1999
       Third Quarter............................................ $ 20.50 $ 8.66
       Fourth Quarter........................................... $ 40.44 $12.75
     Fiscal 2000
       First Quarter (through December 27, 1999)................ $156.94 $20.44
</TABLE>

Recent Closing Prices

   On December 27, 1999, the latest practicable trading day before the printing
of this annual report, the closing price per share of our common stock was
$102.13. As of December 27, 1999, there were 246 holders of record of our
common stock. Because the market price of our common stock is subject to
fluctuation, the market value of the shares of our common stock may increase or
decrease.

Item 6. Selected Financial Data

                SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA
                (in thousands, except share and per share data)

   The following selected historical consolidated financial information should
be read in conjunction with our consolidated financial statements and related
notes and "Management's Discussion and Analysis of Financial Condition and
Results of Operations." The consolidated statement of operations information
for each of the years in the three year period ended September 30, 1999, and
the balance sheet data at September 30, 1998 and 1999, are derived from our
financial statements that have been audited by PricewaterhouseCoopers LLP,
independent accountants, included elsewhere in this filing. The statement of
operations data for the years ended September 30, 1995 and 1996, and the
balance sheet data at September 30, 1995, 1996, and 1997, are derived from our
audited financial statements that are not included in this filing. Historical
results are not necessarily indicative of the results to be expected in the
future.

<TABLE>
<CAPTION>
                                       Year Ended September 30,
                            --------------------------------------------------
                             1995     1996      1997       1998        1999
                            -------  -------  ---------  ---------  ----------
<S>                         <C>      <C>      <C>        <C>        <C>
Consolidated Statement of
 Operations Data:
Revenue.................... $   --   $   --   $     218  $   2,343  $   12,431
Total costs and expenses...       7       26      5,594     19,458      64,918
Loss from operations.......      (7)     (26)    (5,376)   (17,116)    (52,487)
Net loss................... $   (10) $   (27) $  (5,289) $ (16,764) $  (50,938)
                            -------  -------  ---------  ---------  ----------
  Basic and diluted loss
   per share............... $ (0.04) $ (0.10) $   (3.53) $   (7.50) $    (4.58)
                            =======  =======  =========  =========  ==========
  Shares used in basic and
   diluted loss per share
   calculation............. 275,000  275,000  1,497,711  2,236,452  11,127,462
</TABLE>

                                       17
<PAGE>

<TABLE>
<CAPTION>
                                                       September 30,
                                              --------------------------------
                                              1995 1996  1997   1998    1999
                                              ---- ---- ------ ------- -------
<S>                                           <C>  <C>  <C>    <C>     <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents.................... $ 7  $344 $4,584 $ 5,711 $43,315
Investments.................................. --    --   1,983  10,123  31,691
Working capital..............................   5    76  4,613  12,883  59,506
Total assets.................................  93   432  9,223  22,617 107,648
Long-term obligations, including current
 portion..................................... --    --     705   3,992  11,092
Total stockholders' equity................... $86  $ 84 $6,265 $15,490 $79,218
</TABLE>

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations

  Except for the historical financial information contained herein, the matters
discussed in this Annual Report on Form 10-K may be considered "forward-
looking" statements within the meaning of Section 27A of the Securities Act of
1933, as amended, and Section 21E of the Securities Act of 1934, as amended.
Such statements include declarations regarding the intent, beliefs or current
expectations of Digital Island and our management. Such forward-looking
statements are not guarantees of future performance and involve a number of
risks and uncertainties. Actual results could differ materially from those
indicated by such forward-looking statements. We undertake no obligation to
publicly release the results of any revision to these forward-looking
statements which may be made to reflect events or circumstances after the dates
hereof or to reflect the occurrence of unanticipated events. Important factors
which could cause actual results to differ materially from those in the
forward-looking statements, include but are not limited to: the company's short
operating history which makes it difficult to predict its future results of
operations; the company's history of operating losses and expected future
losses which could impede its ability to address the risks and difficulties
encountered by companies in new and rapidly evolving markets; the company's
future operating results could fluctuate which may cause volatility or a
decline in the price of the company's stock; and the company may not be able to
price its services above the overall cost of bandwidth causing its financial
results to suffer.

Overview

   We offer a global network and related services for companies that are using
the Internet to deploy key business applications worldwide. We target
corporations that are increasingly relying on the Internet to conduct business
but are constrained by the unreliability, slow performance and limited range of
functions of the public Internet. The Digital Island Global IP Applications
Network and our services enable customers to effectively deploy and manage
global Internet applications by combining the reliability, performance and
broad range of functions of private intranets with the global access of the
public Internet. We also offer service level guarantees, customized billing,
security services, network management and other application services designed
to improve the performance of applications deployed on our network.

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

   We derive our revenues from a family of services, which include Application
Hosting and Content Distribution Services, consisting of server management,
hardware management and co-location services, and Network Services, consisting
of the sale of open, reserved and managed bandwidth. We currently sell our
services under contracts having terms of one or more years.

   Cost of revenues consists primarily of the cost of contracting for lines
from telecommunication providers worldwide and, to a lesser extent, the cost of
our network operations. We lease lines under contracts of one year or more. The
leasing of transoceanic lines comprises the largest component of our
telecommunications expense, with additional costs arising from leasing local
circuits between our data centers and points of

                                       18
<PAGE>

presence in the United States and international markets. In the future, we
expect to increase the size and number of circuits leased based on increases in
network volume and geographic expansion. The cost of our network operations is
comprised primarily of data centers, equipment maintenance, personnel and
related costs associated with the management and maintenance of the network.

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

Fiscal Years Ended September 30, 1999 and 1998

   Revenue. Revenue increased to $12.4 million for the year ended September 30,
1999 from $2.3 million for the year ended September 30, 1998. The increase in
revenue was due primarily to an increase in the number of billing customers to
83 from 31.

   Cost of Revenue. Cost of revenue increased to $29.5 million for the year
ended September 30, 1999 from $9.0 million for the year ended September 30,
1998. The increase in cost of revenue was due to $17.5 million of spending for
additional network capacity and $3.0 million in recruitment and compensation
costs relating to the addition of network operations personnel.

   Sales and Marketing. Sales and marketing expenses increased to $16.0 million
for the year ended September 30, 1999 from $4.8 million for the year ended
September 30, 1998. This increase was due to $10.6 million of growth in
personnel and related costs and $0.6 million of program expenses.

   Product Development. Product development expenses increased to $6.3 million
for the year ended September 30, 1999 from $1.7 million for the year ended
September 30, 1998. This increase was due to $3.7 million in growth of
personnel and related costs and $0.9 million of costs arising from new product
initiatives, including TraceWare, mirroring and caching technologies.

   General and Administrative. General and administrative expenses increased to
$9.8 million for the year ended September 30, 1999 from $3.4 million for the
year ended September 30, 1998. This increase was due to $2.4 million of
depreciation of network equipment, $2.4 million of growth in personnel and
related expenses, and $1.6 million office facility expenses, legal and
accounting fees and other administrative related expenses.

   Interest Income, net. Interest income, net, increased to $1.6 million for
the year ended September 30, 1999 from $354,000 for the year ended September
30, 1998. This increase was due to a higher average cash balance as a result of
the proceeds of the issuance of shares of our preferred stock, and also common
stock in our initial public offering.

Fiscal Years Ended September 30, 1998 and 1997

   Revenue. Revenue increased to $2.3 million for the year ended September 30,
1998 from $0.2 million for the year ended September 30, 1997. The increase in
revenue was due primarily to an increase in the number of billing customers to
31 from 6.

   Cost of Revenue. Cost of revenue increased to $9.0 million for the year
ended September 30, 1998 from $2.5 million for the year ended September 30,
1997. The increase in cost of revenue was due to $5.7 million of spending for
additional network capacity and $0.8 million in recruitment and compensation
costs relating to the addition of network operations personnel.

                                       19
<PAGE>

   Sales and Marketing. Sales and marketing expenses increased to $4.8 million
for the year ended September 30, 1998 from $1.2 million for the year ended
September 30, 1997. This increase was due to $3.1 million of growth in
personnel and related costs and $0.5 million of program expenses.

   Product Development. Product development expenses increased to $1.7 million
for the year ended September 30, 1998 from $0.4 million for the year ended
September 30, 1997. This increase was due to $1.2 million in growth of
personnel and related costs and $0.1 million of costs arising from new product
initiatives, including TraceWare, mirroring and caching technologies.

   General and Administrative. General and administrative expenses increased to
$3.4 million for the year ended September 30, 1998 from $1.5 million for the
year ended September 30, 1997. This increase was due to $0.7 million of
depreciation of network equipment, $0.7 million of growth in personnel and
related expenses, and $0.5 million office facility expenses, legal and
accounting fees and other administrative related expenses.

   Interest Income, net. Interest income, net, increased to $353,000 million
for the year ended September 30, 1998 from $87,000 for the year ended September
30, 1997. This increase was due to a higher average cash balance as a result of
the proceeds of the issuance of shares of our preferred stock.

Quarterly Results of Operations

   The following tables set forth certain unaudited statements of operations
data for the eight quarters ended September 30, 1999. This data has been
derived from the unaudited interim financial statements prepared on the same
basis as the audited consolidated financial statements contained in this annual
report, and, in the opinion of management, include all adjustments consisting
only of normal recurring adjustments that we consider necessary for a fair
presentation of such information when read in conjunction with the consolidated
financial statements and notes thereto appearing elsewhere in this annual
report. The operating results for any quarter should not be considered
indicative of results of any future period.

<TABLE>
<CAPTION>
                                                    Three Months Ended
                         -------------------------------------------------------------------------------
                         Dec. 31,  Mar. 31,  June 30,  Sept. 30, Dec. 31,  Mar. 31,  June 30,  Sept. 30,
                           1997      1998      1998      1998      1998      1999      1999      1999
                         --------  --------  --------  --------- --------  --------  --------  ---------
                                                      (in thousands)
<S>                      <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>
Statement of Operations
 Data:
Revenue................. $   277   $   414   $   725    $   927  $  1,385  $  2,411  $  3,700  $  4,935
Costs and expenses:
 Cost of revenue........   1,961     2,065     2,267      2,746     2,923     4,827     8,055    13,691
 Sales and marketing....     860       927     1,296      1,764     2,046     3,125     4,525     6,314
 Product development....     214       357       538        585       843     1,167     1,853     2,494
 General and
  administrative........     531       632       902      1,326     1,260     1,703     2,469     4,416
 Stock compensation
  expense...............     --        --        132        355       346       680     1,248       933
                         -------   -------   -------    -------  --------  --------  --------  --------
   Total cost and
    expenses............   3,566     3,981     5,135      6,776     7,418    11,502    18,150    27,848
Loss from operations....  (3,289)   (3,567)   (4,410)    (5,849)   (6,033)   (9,091)  (14,450)  (22,913)
Other income (expense),
 net....................      45        19       123        166        96       160       387       908
                         -------   -------   -------    -------  --------  --------  --------  --------
Loss before income
 taxes..................  (3,244)   (3,548)   (4,287)    (5,683)   (5,937)   (8,931)  (14,063)  (22,005)
                         -------   -------   -------    -------  --------  --------  --------  --------
Provision for income
 taxes..................     --          1       --           1         2       --        --        --
                         -------   -------   -------    -------  --------  --------  --------  --------
   Net loss............. $(3,244)  $(3,549)  $(4,287)   $(5,684) $ (5,939) $ (8,931) $(14,063) $(22,005)
                         =======   =======   =======    =======  ========  ========  ========  ========
</TABLE>

   We expect to experience significant fluctuations in our future results of
operations due to a variety of factors, many of which are outside of our
control, including:

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

                                       20
<PAGE>

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

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

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

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

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

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

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

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

  . bandwidth used by customers may fluctuate from quarter to quarter
    affecting our profits from such customers; and

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

   In addition, a relatively large portion of our expenses are fixed in the
short-term, particularly with respect to telecommunications capacity,
depreciation, real estate and interest expenses and personnel, and therefore
our results of operations are particularly sensitive to fluctuations in
revenues. Due to the foregoing factors, we believe that period-to-period
comparisons of our operating results are not necessarily meaningful and that
such comparisons cannot be relied upon as indicators of future performance.

Liquidity and Capital Resources

   From inception through our initial public offering on June 29, 1999, we
financed our operations primarily through private equity placements of $86.9
million dollars and borrowings under notes payable and capital leases from
financial institutions of $5.7 million. We raised $63.1 million in net proceeds
from our initial public offering. At September 30, 1999, we had cash and cash
equivalents and short-term investments of $75.0 million.

   Net cash used in our operating activities for fiscal 1999 was $39.7 million.
The net cash used by operations was primarily due to working capital
requirements and net losses, offset by increases in accounts payable and
accrued expenses. Net cash used in investing activities was $35.6 million for
fiscal 1999 and was comprised primarily of equipment purchases of $14.3 million
and investments of $52.2 million in commercial paper with maturities of less
than one year, which was offset by proceeds from investments which matured of
$31.5 million. Net cash provided by financing activities was $112.9 million and
was related primarily to the issuance of our Series E preferred stock and our
initial public offering.

   We have a $750,000 revolving line of credit with a commercial bank for the
purpose of financing equipment purchases. As of September 30, 1999, $323,000
was outstanding thereunder. The loan contains standard covenants including
minimum working capital, minimum tangible net worth, debt to equity ratio and
financial reporting requirements. Interest on borrowings thereunder accrues at
the lender's prime rate plus 0.75% (which was 9.00% at September 30, 1999), and
is payable monthly. No further advances were permitted following October 18,
1997, and any outstanding amounts are payable on or before October 18, 2000.

                                       21
<PAGE>

   We also have a $7.5 million line of credit with a commercial bank,
consisting of a revolving credit facility of up to $5 million and other
facilities of up to $2.5 million. As of September 30, 1999, approximately
$230,000 was outstanding under the revolving credit facility, and approximately
$562,000 was outstanding under equipment loan facilities. No further amounts
may be borrowed under the equipment loan facilities. Advances under the line of
credit are limited to a percentage of our recurring contract revenue. The loan
contains standard covenants, including minimum working capital, minimum
tangible net worth, debt to equity ratio and financial reporting requirements.
Interest on borrowings thereunder accrues at the lender's prime rate plus 0.25%
(which was 8.50% at September 30, 1999), and is payable monthly. Under the
terms of the equipment loan facilities, interest is charged at the lender's
prime rate plus 0.75%, which was 9.00% at September 30, 1999. The loans mature
at various times in 2001. Between October 1, 1998 and January 31, 1999, we did
not comply with the minimum tangible net worth and financial reporting
covenants. However, we obtained waivers for all covenant violations. We have
complied with all covenants since January 31, 1999. Additionally, we have
several lease lines of credit. Total borrowings under these lease lines of
credit were $10.0 million at September 30, 1999.

   The execution of our business plan will require substantial additional
capital to fund our operating losses, working capital needs, sales and
marketing expenses, lease payments and capital expenditures. In order to
rapidly improve our competitive position, we anticipate making up to
approximately $80.0 million to $100.0 million of capital expenditures for
network expansion, facilities and related costs in the next 12 months. This
substantial increase in the level of our anticipated capital expenditures will
require up to $100.0 million to $150.0 million of additional financing. We
intend to consider our future financing alternatives, which may include the
incurrence of indebtedness, additional public or private equity offerings or an
equity investment by a strategic partner. Actual capital requirements may vary
based upon the timing and success of the expansion of our operations. Our
capital requirements may change based upon technological and competitive
developments. In addition, several factors may affect our capital requirements:

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

  . our development plans or projections proving to be inaccurate;

  . our engaging in acquisitions or other strategic transactions; or

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

   Other than the current bank note payable and lease financing, we have no
present commitments or arrangements assuring us of any future equity or debt
financing, and there can be no assurance that any such equity or debt financing
will be available to us on favorable terms, or at all. If we do not obtain
additional financing, we believe that our existing cash resources will be
adequate to continue expanding operations on a reduced scale.

Recent Accounting Pronouncements

   On March 4, 1998, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants, or AICPA, issued Statement
of Position No. 98-1, or SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." SOP 98-1 requires computer
software costs related to internal software that are incurred in the
preliminary project stage should be expensed as incurred. Once the
capitalization criteria of SOP 98-1 have been met, external direct costs of
materials and services consumed in developing or obtaining internal-use
computer software; payroll and payroll-related costs for employees who are
directly associated with and who devote time to the internal-use computer
software project (to the extent of the time spent directly on the project); and
interest costs incurred when developing computer software for internal use
should be capitalized. SOP 98-1 is effective for financial statements for
fiscal years beginning after December 15, 1998. Accordingly, we will adopt SOP
98-1 in our consolidated financial statements for the year ending September 30,
2000.

                                       22
<PAGE>

   On April 3, 1998, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position No. 98-5, or SOP 98-5, "Reporting on the Costs of
Start-Up Activities," which provides guidance on the financial reporting of
start-up costs and organization costs. SOP 98-5 requires costs of start-up
activities and organization costs to be expensed as incurred. SOP 98-5 is
effective for financial statements for fiscal years beginning after December
15, 1998. As we have not capitalized such costs, the adoption of SOP 98-5 is
not expected to have a material impact on our consolidated financial
statements.

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

Year 2000 Compliance

   Many currently installed computer systems are not able to distinguish 21st
century dates from 20th century dates. As a result, computer systems and
software that fail to recognize the proper date at the end of this year may
suffer major system failures or miscalculations. If we or our key third party
suppliers fail to achieve year 2000 compliance, we may experience operating
difficulties, including impaired ability to transport data over our network and
impaired ability to bill for our services. We recognize the need to ensure that
our operations will not be adversely affected by year 2000 software failures.
We are assessing the potential overall impact of the impending century change
on our operations.

   Based on our assessment to date, we believe the current versions of our
software products and services are year 2000 compliant, that is, they are
capable of adequately distinguishing 21st century dates from 20th century
dates. However, our products are generally integrated into enterprise systems
involving sophisticated hardware and complex software products, which may not
be year 2000 compliant. We may in the future be subject to claims based on year
2000 problems in others' products, or issues arising from the integration of
multiple products within an overall system. Although we have not been a party
to any litigation or arbitration proceeding to date involving our products or
services and related to year 2000 compliance issues, there can be no assurance
that we will not in the future be required to defend our products or services
in such proceedings, or to negotiate resolutions of claims based on year 2000
issues. The costs of defending and resolving year 2000-related disputes,
regardless of the merits of such disputes, and any potential liability on our
part for year 2000-related damages, including consequential damages, could
cause our business and financial results to suffer. In addition, we believe
that purchasing patterns of customers and potential customers may be affected
by year 2000 issues as companies expend significant resources to correct or
upgrade their current software systems for year 2000 compliance. These
expenditures may reduce funds available to purchase software products such as
those offered by us. To the extent that year 2000 issues cause significant
delay in, or cancellation of, decisions to purchase our products or services,
our business and financial results could suffer.

   We have formulated a contingency plan should we or any of our key third
parties sustain business interruptions caused by year 2000 problems. We have
reviewed our internal management information and other systems in order to
identify and modify any products, services or systems that are not year 2000
compliant. To date, we have not encountered any material year 2000 problems
with our computer systems, applications or any other equipment which might be
subject to these problems. In addition, we received an independent third-party
evaluation of the year 2000 compliance of our network equipment and carriers in
March 1999 and of our computer systems and applications in October 1999. We
will continue to monitor year 2000 compliance for our new products and services
as they arise throughout the remainder of the year.

   Our plan for the year 2000 called for compliance verification of external
vendors supplying software and information systems to us and communication with
significant suppliers to determine their ability to remediate their own year
2000 issues. As part of our assessment, we evaluated the level of validation
required of third parties to ensure their year 2000 readiness. Our business and
our ability to deliver our products and services

                                       23
<PAGE>

could be severely affected, at least for a certain period of time, in the event
that year 2000 related problems were to cause disruption or failure in the
Internet as a means of delivery of our products and services or more generally,
disruption to the infrastructure. The total cost of these year 2000 compliance
activities has not been, and is not anticipated to be, material to our
business, results of operations and financial condition. The costs associated
with addressing any year 2000 related problems that may arise could cause our
business and prospects to suffer.

Item 7a. Quantitative and Qualitative Disclosures About Market Risk

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

                  RISKS FACTORS THAT MAY AFFECT FUTURE RESULTS

                              Risks Related To Us

We have a short operating history.

   Our limited operating history makes it difficult for us to predict future
results of operations, and makes it difficult to evaluate us or our prospects.
We were incorporated in 1994, and began offering our global applications
network services in January 1997. Prior to such time, we were engaged in
activities unrelated to our current operations, and as a result, the results of
operations for such periods are not comparable to our results of operations for
1997 or any subsequent periods.

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

   The revenue and income potential of our business and market is unproven.
From inception, we have experienced operating losses, negative cash flow from
operations and net losses in each quarterly and annual period. For the fiscal
year ended September 30, 1998, our operating loss, negative cash flow from
operations and net loss were $17.1 million, $15.7 million and $16.8 million,
respectively. For the fiscal year ended September 30, 1999, our operating loss,
negative cash flow from operations and net loss were $52.5 million, $39.7
million and $50.9 million, respectively. As of September 30, 1999, we had an
accumulated deficit of approximately $73.1 million.

   Currently, we anticipate making significant investments in our network
infrastructure and product development as well as our sales and marketing
programs and personnel. For example, we have substantially increased the level
of our anticipated capital expenditures for network expansion, facilities and
related costs over the next 12 months to approximately $80.0 million to $100.0
million; this increased level of anticipated capital expenditures will require
significant additional financing, as further described in "Management
Discussion and Analysis of Financial Condition and Results of Operations--
Liquidity and Capital Resources."

                                       24
<PAGE>

Therefore, we believe that we will continue to experience significant losses on
a quarterly and annual basis for the foreseeable future. You must consider us
and our prospects in light of the risks and difficulties encountered by
companies in new and rapidly evolving markets. Our ability to address these
risks depends on a number of factors which include our ability to:

  . market our brand name effectively to companies in our target markets;

  . provide reliable and cost-effective services to attract and retain our
    target customers;

  . continue to grow our infrastructure to accommodate new Internet
    developments and increase utilization of our network to maintain and
    increase our ability to service new and existing customers; and

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

   We may not be successful in meeting these challenges and addressing these
risks and uncertainties. If we are unable to do so, our business will not be
successful and the value of your investment in us will decline.

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

Our operating results may fluctuate in future periods which may cause
volatility or a decline in the price of our stock.

   Due to a variety of factors, we expect to experience significant
fluctuations in our future results of operations, and shortfalls in revenue may
cause significant variations in our operating results in any quarter. Such
fluctuations may cause the price of our stock to fall. Factors, many of which
are out of our control, that could cause our operating results to fluctuate and
our stock price to fall include:

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

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

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

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

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

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

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

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

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

  . bandwidth used by customers may fluctuate from quarter to quarter
    affecting our profits from such customers; and

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

   In addition, a relatively large portion of our expenses are fixed in the
short-term, particularly with respect to telecommunications capacity,
depreciation, real estate, interest and personnel, and therefore our results of
operations are particularly sensitive to fluctuations in revenues. Due to the
foregoing, we believe that period-to-period comparisons of our operating
results are not necessarily meaningful and that such comparisons cannot be
relied upon as indicators of future performance. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations--Quarterly
Results of Operations."

                                       25
<PAGE>

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

   If we do not obtain adequate bandwidth capacity on acceptable terms and
realize appropriate customer volume for such bandwidth, we will not achieve
positive gross profit. We purchase our bandwidth capacity on a fixed-price
basis in advance of the sale of our services for such bandwidth. We sell our
services, by contract, on the basis of actual usage. Our bandwidth costs
currently are exceeding our revenues from the sale of services, which results
in negative gross profit. In the future, we must obtain enough bandwidth to
meet our projected customer needs, and we must realize adequate volume from our
customers to support and justify such bandwidth capacity and expense.

   We expect that our cost to obtain bandwidth capacity for the transport of
data over our network will decline over time as a result of, among other
things, the large amount of capital currently being invested to build
infrastructure providing additional bandwidth. We expect the prices we charge
for data transported over our network will also decline over time as a result
of, among other things, the lower cost of obtaining bandwidth and existing and
new competition in the markets we address. As a result, our historical revenue
rates are not indicative of future revenue based on comparable traffic volumes.
If we fail to accurately predict the decline in costs of bandwidth or, in any
event, if we are unable to sell our services at acceptable prices relative to
our bandwidth costs, or if we fail to offer additional services from which we
can derive additional revenues, our revenues will decrease and our business and
financial results will suffer.

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

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

   We currently incur costs greater than our revenues, and need to increase
customer revenue in order to become profitable. We incur significant fixed
costs to purchase our bandwidth capacity and maintain our network. We also have
payroll and other working capital needs. If we are unable to retain or grow our
customer base, we will not be able to increase our sales and revenues or create
economies of scale to offset our fixed and other operating costs. Our ability
to attract new customers depends on a variety of factors, including:

  . the willingness of businesses to outsource their Internet operations;

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

  . our ability to effectively market such services.

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

  . we may be unsuccessful in implementing our marketing strategies;

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

  . any implemented strategies might not result in increased sales.

Any failure of our network infrastructure could lead to significant costs and
disruptions which could reduce our revenues and harm our business and financial
results.

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

  . human error;

  . fire;

  . natural disasters;


                                       26
<PAGE>

  . power loss;

  . telecommunications failures; and

  . similar events.

   Despite precautions taken by us, the occurrence of a natural disaster or
other unanticipated problems at one or more of our data centers could result in
service interruptions or significant damage to equipment. We have experienced
temporary service interruptions in the past, and we could experience similar
interruptions in the future.

Any failure of our telecommunications providers to provide required data
communications capacity to us could result in interruptions in our services.

   Our operations are dependent upon data communications capacity provided by
third-party telecommunications providers. Any failure of such
telecommunications providers to provide the capacity we require may result in a
reduction in, or termination of, services to our customers. This could cause us
to lose customers or fees charged to such customers, and our business and
financial results could suffer.

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

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

Our failure to make timely upgrades to increase the capacity of our network may
reduce demand for our services.

   Due to the limited deployment of our services to date, the ability of our
network to connect and manage a substantially larger number of customers at
high transmission speeds is as yet unknown. Our network may not be able to be
scaled up to expected customer levels while maintaining superior performance or
that additional network capacity will be available from third-party suppliers
as it is needed by us. In addition, as customers' usage of bandwidth increases,
we will need to make additional investments in our infrastructure to maintain
adequate downstream data transmission speeds, the availability of which may be
limited or the cost of which may be significant. Upgrading our infrastructure
may cause delays or failures in our network. As a result, our network may be
unable to achieve or maintain a sufficiently high capacity of data transmission
as usage by our customers increases. Our failure to achieve or maintain high
capacity data transmission could significantly reduce demand for our services,
reducing our revenues and causing our business and financial results to suffer.

We cannot accurately predict the size of our market, and if our market does not
grow as we expect, our revenues will be below our expectations and our business
and financial results will suffer.

   We are a new company engaging in a developing business with an unproven
market. Accordingly, we cannot accurately estimate the size of our market or
the potential demand for our services. If our customer base does not expand or
if there is not widespread acceptance of our products and our services, our
business and prospects will be harmed. For the fiscal year ended September 30,
1999, we had 83 billing customers, of which one, E*TRADE, accounted for
approximately 35% of our revenues. We believe that our potential to grow and

                                       27
<PAGE>

increase our market acceptance depends principally on the following factors,
some of which are beyond our
control:

  . the effectiveness of our marketing strategy and efforts;

  . our product and service differentiation and quality;

  . the extent of our network coverage;

  . our ability to provide timely, effective customer support;

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

  . our industry reputation; and

  . general economic conditions such as downturns in the computer or software
    markets.

We will require significant additional capital, which we may not be able to
obtain.

   The expansion and development of our business will require significant
capital in the future to fund our operating losses, working capital needs and
capital expenditures. We may not be able to obtain future equity or debt
financing on satisfactory terms or at all. Our failure to generate sufficient
cash flows from sales of services or to raise sufficient funds may require us
to delay or abandon some or all of our development and expansion plans or
otherwise forego market opportunities. In addition, our credit agreements
contain covenants restricting our ability to incur further indebtedness, and
future borrowing instruments such as credit facilities and lease agreements are
likely to contain similar or more restrictive covenants and will likely require
us to pledge assets as security for borrowings thereunder. Our inability to
obtain additional capital on satisfactory terms may delay or prevent the
expansion of our business, which could cause our business and financial results
to suffer.

   Our principal capital expenditures and lease payments include the purchase,
lease and installation of network equipment such as switches, routers, servers
and storage devices. Our working capital is primarily comprised of accounts
receivable, accounts payable and accrued expenses. The timing and amount of our
future capital requirements may vary significantly depending on numerous
factors, including regulatory, technological, competitive and other
developments in its industry. Due to the uncertainty of these factors, our
actual revenues and costs may vary from expected amounts, possibly to a
material degree, and such variations are likely to affect our future capital
requirements. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Liquidity and Capital Resources."

Rapid growth in our business could strain our resources and harm our business
and financial results.

   The planned expansion of our operations will place a significant strain on
our management, financial controls, operations systems, personnel and other
resources. We expect that our customers increasingly will demand additional
information and reports with respect to the services we provide. To handle
these demands and enable future traffic growth, we must develop and implement
an automated customer service system. In addition, if we are successful in
implementing our marketing strategy, we also expect the demands on our network
infrastructure and technical support resources to grow rapidly, and we may
experience difficulties responding to customer demand for our services and
providing technical support in accordance with our customers' expectations. We
expect that these demands will require not only the addition of new management
personnel, but also the development of additional expertise by existing
management personnel and the establishment of long-term relationships with
third-party service vendors. We may not be able to keep pace with any growth,
successfully implement and maintain our operational and financial systems or
successfully obtain, integrate and utilize the employees, facilities, third-
party vendors and equipment, or management, operational and financial resources
necessary to manage a developing and expanding business in our evolving and
increasingly competitive industry. If we are unable to manage growth
effectively, we may lose customers or fail to attract new customers and our
business and financial results will suffer. See "Business--Business Strategy."

                                       28
<PAGE>

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

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

The integration of key new employees and officers into our management team has
interfered, and will continue to interfere, with our operations.

   We have recently hired a number of key employees and officers including our
chief financial officer, vice president of sales and vice president of
corporate development, each of whom has been with us for less than a year. To
integrate into Digital Island, such individuals must spend a significant amount
of time learning our business model and management system, in addition to
performing their regular duties. Accordingly, the integration of new personnel
has resulted and will continue to result in some disruption to our ongoing
operations. If we fail to complete this integration in an efficient manner, our
business and financial results will suffer.

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

   We are highly dependent on key members of our management and engineering
staff, including, without limitation, our president and chief executive
officer, chief technology officer and vice president of marketing. The loss of
one or more of these officers might impede the achievement of our business
objectives. Furthermore, recruiting and retaining qualified technical personnel
to perform research, development and technical support work is critical to our
success. If our business grows, we will also need to recruit a significant
number of management, technical and other personnel for our business.
Competition for employees in our industry is intense. We may not be able to
continue to attract and retain skilled and experienced personnel on acceptable
terms. See "Business--Employees" and "Management."

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

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

                                       29
<PAGE>

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

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

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

   We have applied for trademarks and service marks on certain terms and
symbols that we believe are important for our business. In addition, we
generally enter into confidentiality or license agreements with our employees
and consultants and with our customers and corporations with whom Digital
Island has strategic relationships, and Digital Island attempts to maintain
control over access to and distribution of its software documentation and other
proprietary information. However, the steps we have taken to protect our
technology or intellectual property may be inadequate. Our competitors may
independently develop technologies that are substantially equivalent or
superior to ours. Moreover, in other countries where we do business, there may
not be effective legal protection of patents and other proprietary rights that
we believe are important to our business. See "Business--Intellectual Property
Rights."

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

   Our commercial success will also depend in part on not infringing the
proprietary rights of others and not breaching technology licenses that cover
technology used in our products. It is uncertain whether any third party
patents will require us to develop alternative technology or to alter our
products or processes, obtain licenses or cease activities that infringe on
third party's intellectual property rights. If any such licenses are required,
we may not be able to obtain such licenses on commercially favorable terms, if
at all. Our failure to obtain a license to any technology that we may require
to commercialize our products and services could cause our business and
prospects to suffer. Litigation, which could result in substantial cost to us,
may also be necessary to enforce any patents issued or licensed to us or to
determine the scope and validity of third party proprietary rights. See
"Business--Intellectual Property Rights."

We are subject to risks associated with entering into joint ventures, including
inconsistent goals and exposure to unknown liabilities and unexpected
obligations.

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

                                       30
<PAGE>

Acquisitions we make could disrupt our business and harm our financial
condition.

   We intend to make investments in other complementary companies, products and
technologies in the future. In the event of any future purchases, we could:

  . issue stock that would dilute the ownership of our then existing
    shareholders;

  . incur debt;

  . assume liabilities;

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

  . incur large and immediate write-offs.

   These purchases also involve numerous risks, including:

  . problems integrating the operations, technologies or products purchased
    with those we already have;

  . unanticipated costs;

  . diversion of management's attention from our core business;

  . adverse effects on existing business relationships with suppliers and
    customers;

  . risks associated with entering markets in which we have no or limited
    prior experience; and

  . potential loss of key employees, particularly those of the purchased
    organizations.

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

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

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

   Stock prices and trading volumes for many Internet companies fluctuate
widely for a number of reasons, including some reasons which may be unrelated
to their businesses or results of operations. This market volatility, as well
as general domestic or international economic, market and political conditions,
could materially adversely affect the price of our common stock without regard
to our operating performance. In addition, our operating results may be below
the expectations of public market analysts and investors. If this were to
occur, the market price of our common stock would likely significantly
decrease.

                         RISKS RELATED TO OUR INDUSTRY

We may not be able to compete in our market since it is highly competitive and
has many more established competitors, and we may lose market share as a
result.

   Our market is highly competitive and this competition could harm our ability
to sell our services and products on prices and terms favorable to us. Some of
our current or potential competitors have the financial resources to withstand
substantial price competition, and many may be able to respond more quickly
than we

                                       31
<PAGE>

can to new or emerging technologies and changes in customer requirements.
Moreover, many of our competitors have more extensive customer bases, broader
customer relationships and broader industry alliances that they could use to
their advantage in competitive situations, including relationships with many of
our current and potential customers.

   There are few substantial barriers to entry and we expect that we will face
additional competition from existing competitors and new market entrants in the
future. We compete against information technology and Internet outsourcing
firms, national and regional Internet service providers, and global, regional
and local telecommunications companies.

   Our competitors include companies such as Metromedia/AboveNet
Communications, Inc., AT&T Corp., Exodus Communications, Inc., GTE Corporation,
MCI WorldCom, Inc. and Qwest. Many of our competitors have substantially
greater financial, technical and marketing resources, larger customer bases,
longer operating histories, greater name recognition and more established
relationships in the industry than we do. Our larger competitors may be able to
provide customers with additional benefits in connection with their Internet
systems and network solutions, including reduced communications costs. As a
result, these companies may be able to price their products and services more
competitively than we can and respond more quickly than us to new or emerging
technologies and changes in customer requirements. If we are unable to compete
successfully against our current or future competitors, we may lose market
share, and our business and prospects would suffer.

Our market changes rapidly due to changing technology and evolving industry
standards. If we do not adapt to meet the sophisticated needs of our customers,
our business and prospects will suffer.

   The market for our services is characterized by rapidly changing technology,
evolving industry standards and frequent new service introductions. Our future
success will depend to a substantial degree on our ability to offer services
that incorporate leading technology, address the increasingly sophisticated and
varied needs of our current and prospective customers and respond to
technological advances and emerging industry standards and practices on a
timely and cost-effective basis. You should be aware that:

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

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

  . the price of the services provided by us is expected to decline as
    rapidly as the cost of any competitive alternatives.

   We may not be able to effectively respond to the technological requirements
of the changing market. To the extent we determine that new technologies and
equipment are required to remain competitive, the development, acquisition and
implementation of such technologies and equipment are likely to continue to
require significant capital investment by us. Sufficient capital may not be
available for this purpose in the future, and even if it is available,
investments in new technologies may not result in commercially viable
technological processes and there may not be commercial applications for such
technologies. However, if we do not develop and introduce new products and
services and achieve market acceptance in a timely manner, our business and
prospects may suffer.

Our business and prospects depend on demand for and market acceptance of the
Internet and its infrastructure development.

   The increased use of the Internet for retrieving, sharing and transferring
information among businesses, consumers, suppliers and partners, and for
Internet content delivery services has only begun to develop in recent years.
Our success will depend in large part on continued growth in the use of the
Internet. Critical issues concerning the commercial use of the Internet,
including security, reliability, cost, ease of access, quality of service,
regulatory initiatives and necessary increases in bandwidth availability,
remain unresolved and are

                                       32
<PAGE>

likely to affect the development of the market for our services. The adoption
of the Internet for information retrieval and exchange, commerce and
communications generally will require the acceptance of a new medium of
conducting business and exchanging information. Demand for and market
acceptance of the Internet are subject to a high level of uncertainty and are
dependent on a number of factors, including:

  . the growth in consumer access to and market acceptance of new interactive
    technologies;

  . emergence of a viable and sustainable market for Internet content
    delivery services;

  . the development of technologies that facilitate interactive communication
    between organizations; and

  . increases in user bandwidth.

   If the market for Internet content delivery services or the Internet as a
commercial or business medium does not develop, or develops more slowly than
expected, our business, results of operations and financial condition will be
seriously harmed.

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

   The law relating to the liability of online services companies and Internet
access providers for communications and commerce carried on or disseminated
through their networks is currently unsettled. The most recent session of the
United States Congress resulted in Internet laws regarding children's privacy,
copyrights, taxation and the transmission of sexually explicit material. The
European Union recently enacted its own privacy regulations, and is currently
considering copyright legislation that may extend the right of reproduction
held by copyright holders to include the right to make temporary copies for any
reason. It is possible that claims could be made against online services
companies and Internet access providers under both United States and foreign
law for defamation, negligence, copyright or trademark infringement, or other
theories based on the nature of the data or the content of the materials
disseminated through their networks. Several private lawsuits seeking to impose
such liability upon online services companies and Internet access providers are
currently pending. In addition, the growth and development of the market for
online commerce may prompt calls for more stringent consumer protection laws,
both in the United States and abroad, which may impose additional burdens on
companies conducting business online. Some countries, such as China, regulate
or prohibit the transport of telephony data in their territories. The
imposition upon us and other Internet network providers of potential liability
for information carried on or disseminated through our systems could require us
to implement measures to reduce our exposure to such liability, which may
require the expenditure of substantial resources, or to discontinue some of our
service or product offerings. Our ability to limit the types of data or content
distributed through our network is limited. Failure to comply with such
regulation in a particular jurisdiction could result in fines or penalties or
the termination of our service in such jurisdiction. The increased attention
focused upon liability issues as a result of these lawsuits and legislative
proposals could impact the growth of Internet use. Our professional liability
insurance may not be adequate to compensate or may not cover us in the event we
become liable for information carried on or disseminated through our networks.
Any costs not covered by insurance incurred as a result of such liability or
asserted liability could harm our business and prospects.

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

   We market and sell our network services and products in the United States
and internationally. While the United States represented the majority of our
revenues for fiscal year 1999, we expect the percentage of international sales
to increase over time. We expect to commit significant resources to expand our
international sales and marketing activities throughout year 2000. However, we
may not be able to successfully market, sell, deliver and support our
networking services and products internationally. Furthermore, we may not be
able to maintain or increase market demand for our services, which may harm our
business. However, we may not be

                                       33
<PAGE>

able to successfully market, sell, deliver and support our networking services
and products internationally. We presently conduct our international sales
through local subsidiaries in the United Kingdom, Switzerland, Germany, the
Netherlands, Japan, Malaysia and China and through distributor relationships
with third parties in countries where we have no physical presence. Our failure
to manage our international operations effectively could limit the future
growth of our business, increase our costs, lengthen our sales cycle and
require significant management attention. There are certain risks inherent in
conducting our business internationally, such as:

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

  . export restrictions, tariffs, differing regulatory regimes and other
    trade barriers could impede us from adequately equipping our network
    facilities;

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

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

  . our United States centered accounting operations have limited
    international collection experience and we could have longer accounts
    receivable payment cycles and difficulties in collecting accounts
    receivable in foreign jurisdictions;

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

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

  . increased expenses associated with marketing services in foreign
    countries;

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

  . the risks related to the recent global economic turbulence and adverse
    economic circumstances in Asia.

   Any of these risks could harm our international operations. For example,
some European countries already have laws and regulations related to content
distributed on the Internet and technologies used on the Internet that are more
strict than those currently in force in the United States. Furthermore, there
is an on-going debate in Europe as to the regulation of certain technologies we
use, including caching and mirroring. The European Parliament has recently
adopted a directive relating to the reform of copyright in the European
Community which will, if made into law, restrict caching and mirroring. Any or
all of these factors could cause our business and prospects to suffer. In
addition, we may not be able to obtain the necessary telecommunications
infrastructure in a cost-effective manner or compete effectively in
international markets. See "Business--Business Strategy" and "--Government
Regulation."

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

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

                                       34
<PAGE>

Year 2000 computer complications could disrupt our operations and harm our
business.

   The "year 2000 issue" is the result of computer systems and programs using
two digits rather than four to identify a given year. Computer systems or
programs that have date sensitive software or embedded chips may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result
in system failures or miscalculations or other computer errors causing
disruptions of operations. The potential for failures encompasses all aspects
of our business, including our services, suppliers and customers. These
failures could cause, among other things, disruptions in our operations and a
temporary inability to engage in normal business activities.

   The year 2000 issue creates significant risks for us including:

  . potential warranty or other claims arising from our services;

  . damage to our reputation;

  . litigation costs;

  . impairment of the systems we use to run our business; and

  . impairment of the systems used by our suppliers and customers.

   Although we believe our products are year 2000 compliant, we may see an
increase in warranty and other claims as a result of the year 2000 issues
arising from undetected defects or the non-compliance of the suppliers upon
whom we rely.

   We believe that the most reasonably likely worst-case year 2000 scenario is
the non-compliance of the third-party telecommunications carriers, vendors and
other significant suppliers upon whom we depend for transmission capacity. If
these providers do not achieve year 2000 compliance, we cannot be certain that
we will have sufficient transmission capacity to continue our service without
interruption. However, in the event that any of our other suppliers do not
achieve year 2000 compliance in a timely manner, and we are unable to replace
them with alternate sources, our business and financial results would also be
harmed.

   In addition, virtually all businesses face year 2000 compliance issues and
may require hardware and software upgrades or modifications to their computer
systems and applications. Companies owning and operating these systems may plan
to devote a substantial portion of their information systems' spending to fund
these upgrades and modifications and divert spending away from Internet content
delivery solutions as the year 2000 approaches. Such changes in customers'
spending patterns may reduce our revenues for the next few quarters. Please see
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Year 2000 Compliance" for information on their state of readiness,
potential risks and contingency plans regarding the year 2000 issue.

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

   Our services include the transmission of data over public telephone lines.
These transmissions are subject to the regulatory authority of the Federal
Communications Commission and the state public utility commissions. However, to
date, neither the FCC nor the state public utility commissions has elected to
exercise such authority. Our services could be affected by changes in federal
and state law or regulation in the telecommunications arena, especially changes
relating to telecommunications markets in general and the Internet in
particular. Such changes could directly or indirectly affect our costs, limit
usage or subscriber-related information, and increase the likelihood or scope
of competition from Regional Bell Operating Companies or other
telecommunications companies.

   As our services become available over the Internet in foreign countries, and
as we facilitate sales by our customers to end users located in such foreign
countries, these foreign jurisdictions may decide that we are required to
qualify to do business in the particular foreign country. Such decisions could
subject us to taxes and

                                       35
<PAGE>

other costs. It is also possible that claims could be made against online
service companies and Internet service providers under foreign law for
defamation, negligence, copyright or trademark infringement, or other theories
based on the nature and content of the materials disseminated through their
networks.

   Implementation of any future changes in law or regulation, including those
discussed herein, could cause our business and prospects to suffer. Our
business and prospects may also be harmed by the imposition of certain tariffs,
duties and other import restrictions on facilities and resources that we obtain
from non-domestic suppliers. As a result, changes in law or regulation in the
United States or elsewhere could cause our business and prospects to suffer.
For a more detailed discussion of the possible risks associated with changes in
law or regulation, please see Digital Island's "Business--Government
Regulation."

Item 8. Financial Statements and Supplementary Data

   The Financial Statements and Supplementary Data of Digital Island required
by this item are set forth at the pages indicated at Item 14(a).

Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure

   Not applicable.

                                       36
<PAGE>

                                    PART III

Item 10. Directors and Executive Officers of the Registrant

Officers, Directors and Senior Management

   The following table sets forth the names and ages of our executive officers
and directors and certain members of our senior management as of November 30,
1999.

<TABLE>
<CAPTION>
Name                      Age                               Position
----                      ---                               --------
<S>                       <C> <C>
Ruann F.
 Ernst(1)(4)(5).........   53 Chief Executive Officer, President and Director
T.L. Thompson...........   53 Chief Financial Officer
Chris Albinson..........   32 Vice President of Corporate Development
Paul Evenson............   39 Vice President of Operations
Allan Leinwand..........   33 Vice President of Engineering and Chief Technology Officer
Bruce Pinsky............   36 Vice President of Solutions Engineering and Chief Information Officer
Michael T. Sullivan.....   48 Vice President of Finance
Rick Schultz............   41 Vice President North American Sales
Tim Wilson..............   40 Vice President of Marketing and International Sales
Charlie Bass(2).........   57 Director
Christos Cotsakos(4)....   50 Director
Marcelo A.
 Gumucio(2)(3)(4).......   61 Director
Cliff Higgerson (1)(3)..   57 Director
Shahan Soghikian(1).....   40 Director
David Spreng............   37 Director
</TABLE>
--------
(1) Member of Executive Committee
(2) Member of Compensation Committee
(3) Member of Audit Committee
(4) Member of Nominating Committee
(5) Member of Special Stock Option Committee

   Upon consummation of our merger with Sandpiper Networks, Inc., Leo S.
Spiegel, who is currently the president and chief executive officer of
Sandpiper, will become the president and director of Digital Island, and Scott
Darling, Eric Shepcaro and Andrew Swart, who are officers of Sandpiper, will
become vice president of professional services, vice president of international
and channel sales and vice president of software engineering, respectively, of
Digital Island.

   The merger agreement provides that, upon completion of the merger, the board
of directors of Digital Island shall consist of four designees of Digital
Island, who shall be Ruann Ernst, Cliff Higgerson, Marcelo Gumucio and Shahan
Soghikian; three designees of Sandpiper, who shall be Leo Spiegel, Robert
Kibble and G. Bradford Jones; and two mutually acceptable outside directors,
one of whom shall be Christos Cotsakos and the other of whom shall be mutually
agreed to at a later date.

   Each director will hold office for the term described below in "--Classified
Board" and until such director's successor is elected and qualified or until
such director's earlier resignation or removal. Each officer serves at the
discretion of the board of directors of Digital Island.

   Ruann F. Ernst has served as president and chief executive officer and as a
director since June 1998. Prior to joining Digital Island, Ms. Ernst served
with Hewlett Packard, a computer equipment and services company, for over ten
years, most recently as general manager of the Financial Services Business
Unit. Ms. Ernst has also served as Director, Medical Computing Services
Division and Assistant Professor, Medicine and Computer Science at The Ohio
State University and as a Congressional Fellow in the Office of Technology
Assessment. Ms. Ernst serves on the board of directors of The Institute for the
Future, Phoenix International and Advanced

                                       37
<PAGE>

Fibre Communications, Inc. Ms. Ernst holds a B.S. in Mathematics, a Masters
Degree in Computer Science and a Ph.D. in Technology and Organizational Change
from The Ohio State University.

   Leo S. Spiegel has served as Sandpiper's president and chief executive
officer and as a director of Sandpiper since January 1998. From February 1996
to January 1998, Mr. Spiegel served as senior vice president and chief
technology officer of Donnelley Enterprise Solutions, Inc., an information
management firm. From June 1995 to February 1996, Mr. Spiegel served as a
senior vice president of Donnelley Business Services, a subsidiary of R.R.
Donnelley and Sons Company. From May 1991 to June 1995, Mr. Spiegel was the
executive vice president and chief technology officer of LANSystems, a network
utilities software developer and international systems integration firm which
he co-founded. Mr. Spiegel holds a B.A. from the University of California, San
Diego.

   T.L. Thompson has served as chief financial officer since January 1999. Mr.
Thompson served as chief financial officer of Narrowline, an Internet marketing
firm, from October 1996 to November 1998. From 1989 to 1996 he served in
various financial capacities at Ziff-Davis Publishing Company, most recently as
vice president of business development. Mr. Thompson holds a B.S. in Economics
and an M.B.A. from Northwestern University.

   Chris Albinson has served as vice president of corporate development since
September 1999. From 1993 to August 1999 Mr. Albinson served as assistant vice
president at Newbridge Networks Corp., manufacturer of digital electronic
network products. Mr. Albinson holds an M.B.A. from the University of Western
Ontario.

   Paul Evenson has served as vice president of operations since November 1998.
From 1996 to 1998, Mr. Evenson served as vice president of sales and operations
at Westech Communications, Inc., a communications services firm. From 1986 to
1996, Mr. Evenson served as vice president of information technology at
Montgomery Securities, an investment banking firm. Mr. Evenson studied
Engineering at Oregon State University.

   Scott Darling has served as Sandpiper's vice president of business
development and professional services since May 1999. Mr. Darling has over 18
years of management consulting and business development expertise with such
firms as Andersen Consulting, Price Waterhouse and MCI Systemhouse. Most
recently, Mr. Darling was the managing director for the Worldwide Consumer
Products and Retail and Financial Services vertical practices at MCI
Systemhouse with a heavy focus on e-commerce and web enablement services. Mr.
Darling holds a B.S. in Economics and Business Administration from the
University of Nebraska and an M.B.A. from Colorado State University.

   Allan Leinwand has served as vice president of engineering and chief
technology officer of Digital Island since January 1997 and as a director from
January 1997 to February 1999. Prior to joining Digital Island, from August
1990 to February 1997, Mr. Leinwand served as manager, consulting engineer at
Cisco Systems, a network equipment provider, where he designed and deployed
global internetworks for large corporations, governments and institutions. Mr.
Leinwand also served as a network design and implementation engineer at Hewlett
Packard from 1988 to 1990. Mr. Leinwand holds a B.S. in Computer Science from
the University of Colorado, Boulder.

   Bruce Pinsky has served as vice president of solutions engineering and chief
information officer since March 1997. From August 1992 to March 1997, Mr.
Pinsky worked in Customer Engineering and Global Support Engineering for Cisco
Systems. Mr. Pinsky holds a B.S. in Computer Science from California State
University, Hayward.

   Michael T. Sullivan has served as vice president of finance since May 1997
and served as chief financial officer from October 1997 to January 1999. From
July 1993 to May 1996 Mr. Sullivan served as vice president of operations and
chief financial officer for Tut Systems, a network equipment provider. Mr.
Sullivan holds a B.S. in Business Administration from the University of
California, Berkeley. Mr. Sullivan is a certified public accountant.

                                       38
<PAGE>

   Rick Schultz has served as vice president of north american sales since
March 1999. From December 1995 to February 1999, Mr. Schultz served as vice
president of sales at Pacific Bell Network Integration, a subsidiary of Pacific
Bell, a telecommunications company. Mr. Schultz also held various senior
management positions at AT&T from June 1980 to November 1995 in sales, product
management and sales management. Mr. Schultz holds a B.S. in Commerce from De
Paul University and an M.B.A. from the University of San Francisco.

   Eric Shepcaro has served as Sandpiper's vice president of sales since
January 1998. Mr. Shepcaro has more than 20 years of technical sales and
marketing experience. Prior to joining Sandpiper, Mr. Shepcaro spent over 17
years at Sprint Corporation. Most recently, he served as vice president of
sales engineering and application support, where he led the organization
responsible for technical sales, business development, network engineering,
program, management, and service implementation for business and government
customers. Mr. Shepcaro holds a B.S. in Business from the State University of
New York at Albany and an M.B.A. from San Francisco State University.

   Andrew Swart has served as Sandpiper's vice president of engineering since
January 1998 and as a director of Sandpiper since December 1996. Mr. Swart also
served as Sandpiper's president and chief executive officer from December 1996
to January 1998. From November 1994 to December 1996, Mr. Swart was a managing
director of Sandpiper Consulting LLC. Mr. Swart holds a B.S. in Management
Information Systems from the University of Texas at Dallas.

   Tim Wilson has served as vice president of marketing and international sales
since March 1998. From January 1996 to March 1998, Mr. Wilson served as general
manager within the Business Communications Systems Division of Lucent
Technologies, a telecommunications equipment supplier. Mr. Wilson also served
as executive director and general manager of the Business Communications
Systems Division of AT&T Australia from November 1993 to December 1995. From
August 1983 to October 1993, Mr. Wilson held several management positions in
engineering, sales and marketing at AT&T Corp. and AT&T Bell Laboratories.
Mr. Wilson holds a B.A. in Physics from Bowdoin College and an M.B.A. from the
Fuqua School of Business at Duke University.

   Charlie Bass has served as a director since March 1997. Dr. Bass is trustee
of The Bass Trust, general partner of Bass Associates and a consulting
professor of Electrical Engineering at Stanford University. He is also chairman
of the board of directors of Meridian Data, Inc., Socket Communications, Inc.
and SoloPoint, Inc. and serves on the board of directors of several private
communications companies. Prior to co-founding Ungermann-Bass in 1979, Dr. Bass
was at Zilog, Inc., and prior to the formation of Zilog, Inc. in 1975, he was
on the Electrical Engineering and Computer Sciences faculty at the University
of California at Berkeley from 1972 to 1975. Dr. Bass holds a Ph.D. in
Electrical Engineering from the University of Hawaii where he participated in
the Aloha System research in radio frequency-based computer networks.

   Christos Cotsakos has served as a director of Digital Island since July
1998. Mr. Cotsakos joined E*TRADE, an online financial services company, in
March 1996 as the president and chief executive officer and as a director.
Before joining E*TRADE, he served as president, chief operating officer, co-
chief executive officer and a director of AC Nielsen Inc., a marketing research
company. Prior to joining AC Nielsen, Mr. Cotsakos spent 19 years with Federal
Express Corporation, where he held a number of senior executive positions. In
addition to E*TRADE, Mr. Cotsakos serves on the boards of directors of Fox
Entertainment Group, Inc., National Processing, Inc., Omega Research, Inc. and
Critical Path, Inc., as well as several private companies. A decorated Vietnam
veteran, he received a B.A. from William Paterson College and an M.B.A. from
Pepperdine University. Mr. Cotsakos is currently pursuing a Ph.D. degree in
economics at the University of London.

   Marcelo A. Gumucio has served as a director since January 1998, and served
as chairman of the board of directors from January 1998 until May 1998. He is
the managing partner of Gumucio Burke & Associates, a private investment firm.
In April 1996, Mr. Gumucio joined Micro Focus PLC, an enterprise software
provider, as its chief executive officer. He had served as a non-executive
director of Micro Focus' board of directors since January 1996. Prior to
joining Micro Focus, from 1992 to 1996, Mr. Gumucio was president, chief

                                       39
<PAGE>

executive officer and chairman of the board of directors of Memorex Telex NV.
Mr. Gumucio's professional experience in the computer and communications
industry spans almost 30 years and includes senior management positions at Cray
Research, Inc., Northern Telecom Limited, Memorex Corporation and Hewlett-
Packard Company. Mr. Gumucio serves on the board of directors of BidCom Inc.,
E-Stamp Corporation and Burr Brown Corporation. Mr. Gumucio graduated cum laude
with a B.S. in mathematics from the University of San Francisco in 1961. He
received an M.S. in applied mathematics and operations research in 1963 from
the University of Idaho, where he was named a National Science Fellow and
graduated with honors. In 1982, he graduated from the Harvard Business School
Advanced Management Program.

   Cliff Higgerson has served as a director since March 1997. Mr. Higgerson has
over 20 years experience with venture capital investments. Prior to forming
Communications Ventures II in the summer of 1997, he was a general partner of
Vanguard Venture Partners, where he has been since 1993 and where he continues
to manage several portfolio companies. His 25 years of involvement in the
communications field include research, consulting, planning, investment
banking, and venture capital. Mr. Higgerson serves on the board of directors of
Advanced Fibre Communications, Inc., Ciena Corp. and Digital Microwave Corp.,
as well as several private companies. Mr. Higgerson holds a B.S. in electrical
engineering and an M.B.A. from the Haas School of Business at the University of
California at Berkeley.

   Shahan Soghikian has served as a director since February 1999. Mr. Soghikian
has over nine years experience with venture capital investments and is a
general partner of Chase Capital Partners, where he has been since 1990, and
where he develops, executes and monitors investments in private companies.
Mr. Soghikian serves on the board of directors of two private companies, Nextec
Applications, Inc. and AFS Holdings. Mr. Soghikian graduated with a B.A. in
Biology from Pitzer College and an M.B.A. from Anderson School of Business at
the University of California at Los Angeles.

   David Spreng has served as a director since July 1997. Mr. Spreng has over
10 years of venture capital investment experience, primarily in communications,
and served as president of IAI Ventures, the private equity arm of Investment
Advisers, Inc. from 1992 until September 1998, when Mr. Spreng became the
managing member of the general partners of the successor in interest to IAI
Ventures and IAI, the Crescendo Funds and its management company. Mr. Spreng
serves on the board of directors of Tut Systems, Inc. and several private
companies. Mr. Spreng graduated from the University of Minnesota with a B.S. in
Accounting.

Director Compensation

   Our directors do not currently receive compensation for their services as
members of the board of directors. All directors are reimbursed for their
reasonable out-of-pocket expenses in serving on the board of directors or any
committee thereof. Employee directors are eligible to participate in our 1998
stock option/stock issuance plan and will also be eligible to receive equity
incentives, in the form of stock option grants or direct stock issuances, under
our 1999 stock incentive plan.

   Non-employee board members will receive option grants at periodic intervals
under the automatic option grant program of the 1999 stock incentive plan and
will also be eligible to receive discretionary option grants under the
discretionary option grant program of such plan. See "Executive Compensation
and Other Information--Employee Benefit Plans."

Classified Board

   Our certificate of incorporation provides for a classified board of
directors consisting of three classes of directors, each serving staggered
three-year terms. As a result, a portion of our board of directors will be
elected each year. David Spreng has been designated a Class I director whose
term expires at the 2000 annual meeting of stockholders. Mr. Ron Higgins, our
former chairman, was a Class I director; he resigned on September 28, 1999 and
his seat is vacant. Charlie Bass, Cliff Higgerson and Shahan Soghikian have
been designated Class II directors whose term expires at the 2001 annual
meeting of stockholders. Christos

                                       40
<PAGE>

Cotsakos, Ruann Ernst and Marcelo Gumucio have been designated Class III
directors whose term expires at the 2002 annual meeting of stockholders. See
"Description of Capital Stock--Antitakeover Effects of Provisions of Certain
Charter Provisions, Bylaws and Delaware Law."

Board Committees

   The executive committee of our board of directors consists of Ruann Ernst,
Cliff Higgerson and Shahan Soghikian. The executive committee, subject to the
following limitations, acts upon all matters concerning our interests, and
manages our business when the full board of directors is not in session. Our
executive committee may not:

  . adopt, amend or repeal the bylaws;

  . elect directors to fill vacancies on the board;

  . fill vacancies on the executive committee, or change its membership;

  . elect to remove officers of Digital Island;

  . amend the corporate charter;

  . act on matters assigned to other committees of the board;

  . appoint standing committees of the board;

  . recommend to the stockholders any action requiring their approval; or

  . approve the acquisition or disposal of any capital asset or assets to be
    used by us or any subsidiary in an amount exceeding an aggregate
    $3,000,000 in any interim period between meetings of the board.

   The audit committee of the board of directors consists of Marcelo Gumucio
and Cliff Higgerson. The audit committee reviews our financial statements and
accounting practices, makes recommendations to the board of directors regarding
the selection of independent auditors and reviews the results and scope of our
annual audit and other services provided by our independent auditors.

   The compensation committee of the board of directors consists of Charlie
Bass and Marcelo Gumucio. The compensation committee makes recommendations to
the board of directors concerning salaries and incentive compensation for our
officers and employees and administers our employee benefit plans including the
grant of options under those plans.

   The nominating committee of the board of directors consists of Christos
Cotsakos, Ruann Ernst and Marcelo Gumucio. The nominating committee makes
recommendations to the board of directors concerning candidates for
directorships.

   The special stock option committee of the board of directors consists solely
of Ruann Ernst. The special stock option committee has the authority, separate
from the compensation committee, to make discretionary option grants to
eligible individuals other than officers or non-employee members of the board
of directors.

Compensation Committee Interlocks and Insider Participation

   None of the members of the compensation committee of the board of directors
was at any time since the formation of Digital Island an officer or employee of
Digital Island. No executive officer of Digital Island serves as a member of
the board of directors or compensation committee of any entity that has one or
more executive officers serving on our board of directors or our compensation
committee of the board of directors.

                                       41
<PAGE>

Item 11. Executive Compensation

Summary of Cash and Certain Other Compensation

   The following table sets forth the compensation earned by our named
executive officers which include our chief executive officer and our four other
executive officers whose salary and bonus for services rendered in all
capacities to Digital Island for the fiscal year ended September 30, 1999
exceeded $100,000. For a list of our current executive officers and certain
members of senior management, see "Management."

   The options listed in the following table were originally granted under
either our 1997 stock option and incentive plan or our 1998 stock option/stock
issuance plan. These options have been incorporated into the new 1999 stock
incentive plan, but will continue to be governed by their existing terms. See
"Executive Compensation and Other Information--Employee Benefit Plans."

<TABLE>
<CAPTION>
                                                                     Long Term
                                                                    Compensation
                                 Annual Compensation                   Awards
                                ---------------------               ------------
                                                                     Number of
                                                                     Securities
                                                      Other Annual   Underlying
Name and Principal Position(s)  Year  Salary   Bonus  Compensation    Options
------------------------------  ---- -------- ------- ------------  ------------
<S>                             <C>  <C>      <C>     <C>           <C>
Ruann F. Ernst................  1999 $185,961 $64,250   $24,620(1)   1,044,159
 President and Chief Executive
  Officer
Allan Leinwand................  1999  163,333  44,000       --         323,000
 Chief Technology Officer
Ron Higgins(2)................  1999  150,000  40,000       --         400,000
 Chairman of the Board of
  Directors
Tim Wilson....................  1999  180,446  51,250       --         280,000
 Vice President of Marketing
  and International Sales
Paul Evenson..................  1999  146,635  27,222       --         200,000
 Vice President of Operations
</TABLE>
--------
(1) Consists of reimbursement of rent for Ms. Ernst's apartment in San
    Francisco, California.
(2) Mr. Higgins served as President and Chief Executive Officer of Digital
    Island from February 1994 until June 1998 and Chairman of the Board of
    Directors from June 1998 to September 1999.

Stock Options and Stock Appreciation Rights

   The following table sets forth information regarding option grants to each
of the named executive officers during the fiscal year ended September 30,
1999. No stock appreciation rights were granted to the named executive officers
during the 1999 fiscal year.

                    Stock Option Grants in Fiscal Year 1999

<TABLE>
<CAPTION>
                                                                 Potential
                                                            Realizable Value at
                  Number of  Percentage                       Assumed Annual
                  Securities  of Total  Exercise              Rates of Stock
                  Underlying  Options    Price              Price Appreciation
                   Options   Granted to   Per                 for Option Term
                   Granted   Employees    Share  Expiration -------------------
      Name           (#)      in 1999    ($/Sh)     Date       5%        10%
      ----        ---------- ---------- -------- ---------- -------- ----------
<S>               <C>        <C>        <C>      <C>        <C>      <C>
Ruann F. Ernst...  250,000      10.4%    $4.25     3/18/09  $668,201 $1,693,351
Allan Leinwand...   35,000       1.5%     4.25     3/18/09    93,548    237,069
Ron Higgins......      --        --        --          --        --         --
Tim Wilson.......   40,000       1.7%     3.50    10/16/08    88,045    223,124
Tim Wilson.......  100,000       4.1%     4.25     3/18/09   267,280    677,341
Paul Evenson.....  150,000       6.2%     3.50    10/26/08   330,170    836,715
Paul Evenson.....   50,000       2.1%     4.25     3/18/09   133,640    338,670
</TABLE>

                                       42
<PAGE>

   The exercise price per share of each option was determined by our board of
directors in its good faith judgment and generally reflects its best estimate
of the fair value of our common stock on the date of each grant, taking into
account factors such as our operating performance, recent sales of securities,
and market conditions.

   Each option has a maximum term of 10 years, subject to earlier termination
upon the optionee's cessation of service with Digital Island. Ms. Ernst was
granted an option for 250,000 shares with an exercise price of $4.25 per share.
The first 234,373 shares, subject to her options, will vest in a series of 45
successive equal monthly installments upon her completion of each month of
service over the 45-month period measured from March 18, 1999, and the
remaining 15,627 shares will vest in a series of 3 successive equal monthly
installments over the 3-month period measured from December 18, 2002. The
option granted to Mr. Leinwand for 35,000 shares began to vest starting March
18, 1999 in 48 successive equal monthly installments. The option granted Mr.
Wilson for 40,000 shares is vested for 9,600 shares on October 16, 1999, and
vests in a series of 38 successive equal monthly installments upon his
completion of service measured from October 16, 1999. The option Mr. Wilson was
granted for 100,000 shares began to vest starting March 18, 1999 in 48
successive equal monthly installments. The option granted Mr. Evenson for
150,000 shares is vested for 36,000 shares on October 26, 1999 and vests in a
series of 38 successive equal monthly installments upon his completion of
service measured from October 29, 1999. The option Mr. Evenson was granted for
50,000 shares began to vest starting October 26, 1999 in 48 successive equal
monthly installments.

   The actual stock price appreciation over the 10-year option term may not be
at the above 5% and 10% assumed annual rates of compounded stock price
appreciation or at any other defined level. Unless the market price of common
stock appreciates over the option term, no value will be realized from the
option grant made to the named executive officer.

Aggregated Option/SAR Exercises and Fiscal Year-End Values

   The following table sets forth information with respect to the named
executive officers concerning their exercise of stock options during the fiscal
year ended September 30, 1999 and the number of shares subject to unexercised
stock options held by them as of the close of such fiscal year. No stock
appreciation rights were exercised during the fiscal year ended September 30,
1999, and no stock appreciation rights were outstanding at the close of such
year. In the following table, "Value Realized" is equal to the difference
between the fair value of the shares at the time of exercise ($9.90 per share)
and the exercise price paid for the shares and the "Value of Unexercised In-
The-Money Options at Year-End" is based upon the fair value per share at the
close of the 1999 fiscal year ($26.00 per share) less the exercise price
payable per share.

            Aggregated Option Exercises in 1999 and Year-End Values

<TABLE>
<CAPTION>
                                                     Number of Securities  Value of Unexercised
                                                    Underlying Unexercised In-the-Money Options
                                           Value     Options at Year-End       at Year-End
                         Shares Acquired  Realized  ---------------------- --------------------
          Name           on Exercise (#)    ($)          Exercisable          Unexercisable     Exercisable Unexercisable
          ----           --------------- ---------- ---------------------- -------------------- ----------- -------------
<S>                      <C>             <C>        <C>                    <C>                  <C>         <C>
Ruann F. Ernst..........     133,332     $1,119,989        392,076               418,751        $9,519,925   $9,657,837
Allan Leinwand..........     163,733      1,555,464         14,775               144,492           361,396    3,528,289
Ron Higgins.............     216,000      2,052,000         42,333               141,667         1,083,725    3,626,675
Tim Wilson..............      53,249        445,307         49,649               177,102         1,134,256    4,152,129
Paul Evenson............         --             --             --                200,000               --     4,462,500
</TABLE>

                                       43
<PAGE>

Employee Benefit Plans

 1999 Stock Incentive Plan

   Our 1999 stock incentive plan is the successor equity incentive program to
our 1998 stock option/stock issuance plan which was the successor equity
incentive program to our 1997 stock option and incentive plan. The 1999 stock
incentive plan became effective on June 29, 1999, the effective date of our
initial public offering. All outstanding options under our predecessor plan
were at that time incorporated into the 1999 stock incentive plan, and no
further option grants will be made under such predecessor plan. The
incorporated options will continue to be governed by their existing terms,
unless the plan administrator elects to extend one or more features of the 1999
stock incentive plan to those options. Except as otherwise noted below, the
incorporated options have substantially the same terms as will be in effect for
grants made under the discretionary option grant program of the 1999 stock
incentive plan.

   An initial reserve of 7,544,000 shares of common stock has been authorized
for issuance under the 1999 stock incentive plan. This share reserve consists
of (i) the number of shares estimated to remain available for issuance under
our predecessor plan, including the shares subject to outstanding options
thereunder, plus (ii) an additional increase of approximately 2,500,000 shares.
The number of shares of common stock reserved for issuance under the 1999 stock
incentive plan will automatically increase on the first trading day in January
each calendar year, beginning in calendar year 2000, by an amount equal to four
percent (4%) of the total number of shares of common stock outstanding on the
last trading day in December in the preceding calendar year, but in no event
will this annual increase exceed 2,000,000 shares. In addition, no participant
in the 1999 stock incentive plan may be granted stock options, separately
exercisable stock appreciation rights and direct stock issuances for more than
750,000 shares of common stock in the aggregate per calendar year.

   The 1999 stock incentive plan is divided into five separate components:

  . the discretionary option grant program, under which eligible individuals
    in Digital Island's employ or service (including officers, non-employee
    board members and consultants) may, at the discretion of the plan
    administrator, be granted options to purchase shares of common stock at
    an exercise price not less than 100% of the fair market value of those
    shares on the grant date;

  . the stock issuance program under which eligible individuals may, in the
    plan administrator's discretion, be issued shares of common stock
    directly, upon the attainment of designated performance milestones or
    upon the completion of a specified service requirement or as a bonus for
    past services;

  . the salary investment option grant program, which may, at the plan
    administrator's sole discretion, be activated for one or more calendar
    years and, if so activated, will allow executive officers and other key
    executives selected by the plan administrator the opportunity to apply a
    portion of their base salary each year to the acquisition of special
    below-market stock option grants;

  . the automatic option grant program, under which option grants will
    automatically be made at periodic intervals to eligible non-employee
    board members to purchase shares of common stock at an exercise price
    equal to 100% of the fair market value of those shares on the grant date;
    and

  . the director fee option grant program, which may, in the plan
    administrator's sole discretion, be activated for one or more calendar
    years and, if so activated, will allow non-employee board members the
    opportunity to apply all or a portion of the annual retainer fee
    otherwise payable to them in cash each year to the acquisition of special
    below-market option grants.

   The discretionary option grant program and the stock issuance program are
administered by the compensation committee. However, a secondary committee of
one or more board members also has concurrent authority to administer those
programs with respect to individuals who are neither officers nor directors.
The compensation committee or secondary committee as plan administrator have
complete discretion to determine which eligible individuals are to receive
option grants or stock issuances under those programs, the time or

                                       44
<PAGE>

times when the grants or issuances are to be made, the number of shares subject
to each grant or issuance, the status of any granted option as either an
incentive stock option or a non-statutory stock option under the Federal tax
laws, the vesting schedule to be in effect for the option grant or stock
issuance and the maximum term for which any granted option is to remain
outstanding. However, the board acting by a disinterested majority has the
exclusive authority to make any discretionary option grants or stock issuances
to members of the compensation committee. The compensation committee has the
exclusive authority to select the executive officers and other highly
compensated employees who may participate in the salary investment option grant
program in the event that program is activated for one or more calendar years.
Neither the compensation committee nor the board will exercise any
administrative discretion with respect to option grants under the salary
investment option grant program or under the automatic option grant or director
fee option grant program for the non-employee board members. All grants under
those latter three programs will be made in strict compliance with the express
provisions of each program.

   The exercise price for the shares of common stock subject to option grants
made under the 1999 stock incentive plan may be paid in cash or in shares of
common stock valued at fair market value on the exercise date. The option may
also be exercised through a same-day sale program without any cash outlay by
the optionee.

   The plan administrator has the authority to effect the cancellation of
outstanding options under the discretionary option grant program (including
options incorporated from our predecessor plan) in return for the grant of new
options for the same or different number of option shares with an exercise
price per share based upon the fair market value of the common stock on the new
grant date.

   Stock appreciation rights are authorized for issuance under the
discretionary option grant program. These rights will provide the holders with
the election to surrender their outstanding options for an appreciation
distribution from us equal to the excess of (a) the fair market value of the
vested shares of common stock subject to the surrendered option over (b) the
aggregate exercise price payable for those shares. Such appreciation
distribution may be made in cash or in shares of common stock. None of the
incorporated options from our predecessor plan contain any stock appreciation
rights.

   In the event that we are acquired by merger or asset sale, each outstanding
option under the discretionary option grant program which is not to be assumed
by the successor corporation will automatically accelerate in full, and all
unvested shares under the discretionary option grant and stock issuance
programs will immediately vest, except to the extent our repurchase rights with
respect to those shares are to be assigned to the successor corporation. The
plan administrator has complete discretion to grant one or more options under
the discretionary option grant program which will vest and become exercisable
for all the option shares in the event those options are assumed in the
acquisition and the optionee's service with us or the acquiring entity is
terminated within a designated period (not to exceed eighteen months) following
that acquisition. The vesting of outstanding shares under the stock issuance
program may be accelerated upon similar terms and conditions.

   The plan administrator is also authorized to grant options and structure
repurchase rights so that the shares subject to those options or repurchase
rights will immediately vest in connection with a change in ownership or
control (whether by successful tender offer for more than fifty percent of our
outstanding voting stock or by a change in the majority of our board through
one or more contested elections for board membership). Such accelerated vesting
may occur either at the time of such change or upon the subsequent termination
of the individual's service within a designated period (not to exceed eighteen
months) following the change.

   The options to be incorporated from our predecessor plan will immediately
vest and become exercisable for all the option shares if we are acquired by
merger or asset sale, unless the options are assumed by the successor
corporation and our repurchase rights with respect to the unvested shares
subject to those options are concurrently assigned to the successor entity. For
some of these options, the board also has the authority to provide for their
cancellation in return for a cash payment to the option holders in an amount
per cancelled option share equal to the excess of the price to be paid per
share of our common stock in the acquisition over

                                       45
<PAGE>

the option exercise price payable per share under the cancelled option. Other
of these options contain a special acceleration feature. Under that feature,
should the optionee's service be terminated within a designated period
following an acquisition in which the option is assumed and our repurchase
rights are assigned, then the option will vest at that time and become
immediately exercisable for all the option shares, and all unvested shares held
by such individual will also vest at that time. There are no other change in
control provisions currently in effect for the outstanding options under the
predecessor plan. However, the plan administrator will have the discretion to
extend the acceleration provisions of the 1999 stock incentive plan to any or
all of the options outstanding under our predecessor plan.

   In the event the plan administrator elects to activate the salary investment
option grant program for one or more calendar years, each executive officer and
other key employee selected for participation may elect, prior to the start of
the calendar year, to reduce his or her base salary for that calendar year by a
specified dollar amount not less than $10,000 nor more than $50,000. Each
selected individual who files this timely election will automatically be
granted, on the first trading day in January of the calendar year for which
that salary reduction is to be in effect, a non-statutory option to purchase
that number of shares of common stock determined by dividing the salary
reduction amount by two-thirds of the fair market value per share of common
stock on the grant date. The option will be exercisable at a price per share
equal to one-third of the fair market value of the option shares on the grant
date. As a result, the total spread on the option shares at the time of grant
(the fair market value of the option shares on the grant date less the
aggregate exercise price payable for those shares) will be equal to the amount
of salary invested in that option. The option will vest and become exercisable
in a series of twelve equal monthly installments over the calendar year for
which the salary reduction is to be in effect.

   Under the automatic option grant program, eligible non-employee board
members will receive a series of option grants over their period of board
service. Each individual who first becomes a non-employee board member at any
time at or after the effective date of this offering will receive an option
grant for 15,000 shares of common stock on the date such individual joins the
board, provided such individual has not been in our prior employ. In addition,
on the date of each annual stockholders meeting held after the effective date
of this offering, each non-employee board member who is to continue to serve as
a non-employee board member (including the individuals who are currently
serving as non-employee board members) will automatically be granted an option
to purchase 5,000 shares of common stock, provided such individual has served
on the board for at least six months. There will be no limit on the number of
such 5,000 share option grants any one eligible non-employee board member may
receive over his or her period of continued board service, and non-employee
board members who have previously been in our employ will be eligible to
receive one or more such annual option grants over their period of board
service.

   Each automatic grant will have an exercise price per share equal to the fair
market value per share of common stock on the grant date and will have a term
of 10 years, subject to earlier termination following the optionee's cessation
of board service. Each automatic option will be immediately exercisable for all
of the option shares; however, any unvested shares purchased under the 15,000-
share option will be subject to repurchase by Digital Island, at the exercise
price paid per share, should the optionee cease to serve on the board prior to
vesting in those shares. The shares subject to each initial 15,000-share
automatic option grant will vest in a series of six successive equal semi-
annual installments upon the optionee's completion of each month of board
service over the 36 month period measured from the grant date. However, the
shares will immediately vest in full upon certain changes in control or
ownership or upon the optionee's death or disability while a board member. The
shares subject to each annual 5,000-share automatic grant will be fully-vested
when granted. Following the optionee's cessation of board service for any
reason, each option will remain exercisable for a 12-month period and may be
exercised during that time for any or all shares in which the optionee is
vested at the time of such cessation of service.

   If the director fee option grant program is activated in the future, each
non-employee board member will have the opportunity to apply all or a portion
of any annual retainer fee otherwise payable in cash to the

                                       46
<PAGE>

acquisition of a below-market option grant. The option grant will automatically
be made on the first trading day in January in the year for which the retainer
fee would otherwise be payable in cash. The option will have an exercise price
per share equal to one-third of the fair market value of the option shares on
the grant date, and the number of shares subject to the option will be
determined by dividing the amount of the retainer fee applied to the program by
two-thirds of the fair market value per share of common stock on the grant
date. As a result, the total spread on the option (the fair market value of the
option shares on the grant date less the aggregate exercise price payable for
those shares) will be equal to the portion of the retainer fee invested in that
option. The option will vest and become exercisable for the option shares in a
series of twelve equal monthly installments over the calendar year for which
the election is to be in effect. However, the option will become immediately
exercisable and vested for all the option shares upon (a) certain changes in
the ownership or control or (b) the death or disability of the optionee while
serving as a board member.

   The shares subject to each option under the salary investment option grant,
automatic option grant and director fee option grant programs will immediately
vest upon (a) an acquisition of us by merger or asset sale or (b) the
successful completion of a tender offer for more than 50% of our outstanding
voting stock or a change in the majority of our board effected through one or
more contested elections for board membership.

   Limited stock appreciation rights will automatically be included as part of
each grant made under the automatic option grant, salary investment option
grant and director fee option grant programs and may be granted to one or more
officers as part of their option grants under the discretionary option grant
program. Options with this limited stock appreciation right may be surrendered
to Digital Island upon the successful completion of a hostile tender offer for
more than 50% of our outstanding voting stock. In return for the surrendered
option, the optionee will be entitled to a cash distribution from us in an
amount per surrendered option share equal to the excess of (a) the highest
price per share of common stock paid in connection with the tender offer over
(b) the exercise price payable for such share.

   The board may amend or modify the 1999 stock incentive plan at any time,
subject to any required stockholder approval. The 1999 stock incentive plan
will terminate on the earliest of (a) April 15, 2009, (b) the date on which all
shares available for issuance under the 1999 stock incentive plan have been
issued as fully-vested shares or (c) the termination of all outstanding options
in connection with certain changes in control or ownership.

 1999 Employee Stock Purchase Plan

   Our 1999 employee stock purchase plan became effective on June 29, 1999, the
date of execution of the underwriting agreement relating to our initial public
offering. The plan is designed to allow our eligible employees and those of our
participating subsidiaries to purchase shares of common stock, at semi-annual
intervals, through their periodic payroll deductions under the plan. 300,000
shares of common stock will initially be reserved for issuance under the plan.
The reserve will automatically increase on the first trading day in January
each year, beginning in calendar year 2000, by an amount equal to one percent
(1%) of the total number of outstanding shares of our common stock on the last
trading day in December in the prior year. In no event will any such annual
increase exceed 500,000 shares.

   The plan will be implemented in a series of successive offering periods,
each with a maximum duration of 24 months. However, the initial offering period
began on the execution date of the underwriting agreement for our initial
public offering and will end on the last business day in July 2001. The next
offering period will commence on the first business day in August 2001, and
subsequent offering periods will commence as designated by the plan
administrator.

   Individuals who are eligible employees (employees scheduled to work more
than 20 hours per week for more than five calendar months per year) on the
start date of any offering period may enter the plan on that start date or on
any subsequent semi-annual entry date (the first business day of February or
August each year). Individuals who become eligible employees after the start
date of the offering period may join the plan on any subsequent semi-annual
entry date within that offering period.

                                       47
<PAGE>

   Payroll deductions may not exceed 15% of the participant's base salary, and
the accumulated payroll deductions of each participant will be applied to the
purchase of shares on his or her behalf on each semi-annual purchase date (the
last business day in January and July each year) at a purchase price per share
equal to 85% of the lower of (a) the fair market value of the common stock on
the participant's entry date into the offering period or (b) the fair market
value on the semi-annual purchase date. In no event, however, may any
participant purchase more than 1,200 shares on any semi-annual purchase date,
nor may all participants in the aggregate purchase more than 200,000 shares on
any semi-annual purchase date. The initial purchase date under the plan will
occur on January 31, 2000.

   If the fair market value per share of our common stock on any purchase date
is less than the fair market value per share on the start date of the two-year
offering period, then that offering period will automatically terminate, and a
new two-year offering period will begin on the next business day, with all
participants in the terminated offering to be automatically transferred to the
new offering period.

   Should we be acquired by merger, sale of substantially all our assets or
sale of securities possessing more than fifty percent of the total combined
voting power of our outstanding securities, then all outstanding purchase
rights will automatically be exercised immediately prior to the effective date
of that acquisition. The purchase price will be equal to 85% of the lower of
(a) the fair market value per share of common stock on the participant's entry
date into the offering period in which the acquisition occurs or (b) the fair
market value per share of common stock immediately prior to the acquisition.
The limitation on the maximum number of shares purchasable in the aggregate on
any one purchase date will not be in effect for any purchase date attributable
to such an acquisition.

   The plan will terminate on the earlier of (a) the last business day of July
2009, (b) the date on which all shares available for issuance under the plan
shall have been sold pursuant to purchase rights exercised thereunder or (c)
the date on which all purchase rights are exercised in connection with an
acquisition of us by merger or asset sale.

   The board may at any time alter, suspend or discontinue the plan. However,
certain amendments, such as increasing the number of shares reserved for
issuance under the plan, require stockholder approval.

 401(k)Plan

   We sponsor the Digital Island, Inc. 401(k) Plan. Employees who complete
three months of service with us are eligible to participate in the 401(k) Plan
and may contribute up to 15% of their current compensation, but in no event may
they contribute more than the maximum dollar amount allowable per calendar year
under the federal tax laws. Each participant is fully vested in his or her
salary reduction contributions. Participant contributions are held in trust and
the individual participants may direct the trustee to invest their accounts in
a number of investment alternatives. We may make contributions to the 401(k)
Plan which match a percentage of each participant's contributions for the year,
with the actual percentage match (if any) for one or more plan years to be
determined by us in our discretion. In addition, we may make discretionary
contributions for one or more plan years which would be allocated to
participants on the basis of their compensation for the plan year. Any
discretionary and matching contributions which we may make to the 401(k) Plan
would be subject to a vesting schedule tied to the participant's years of
service with us. To date, we have not made any matching or discretionary
contributions to the 401(k) Plan. We may also make fully vested qualified non-
elective contributions to the 401(k) Plan on behalf of participants who are not
"highly compensated," but have not done so to date.

Employment Contracts and Change of Control Arrangements

   We have entered into employment agreements with Ms. Ernst, Mr. Leinwand, Mr.
Wilson and Mr. Evenson, each of whom is an officer of Digital Island. All
outstanding options held by the foregoing officers will automatically vest in
full upon an acquisition of us by merger, sale of substantially all the assets
or

                                       48
<PAGE>

sale of more than 50% of our outstanding voting securities, unless those
options are assumed or otherwise continued in effect by a successor entity or
our repurchase rights for any unvested shares subject to those options are to
remain in force following such acquisition. The exercise price per share of the
options below were determined by our board of directors as described in "--
Stock Options and Stock Appreciation Rights."

   Ruann F. Ernst. On May 20, 1998, Ruann F. Ernst, our chief executive officer
and president, entered into an employment agreement with Digital Island. This
agreement provided for an annual salary of $150,000. Ms. Ernst is also entitled
to incentive compensation in an amount not less than forty percent (40%) of her
base salary upon the achievement of performance milestones mutually agreed upon
with our board of directors. On March 1, 1999, Ms. Ernst's annual salary was
increased to $200,000. In connection with her employment agreement, we granted
Ms. Ernst options to purchase up to 794,159 shares of our common stock at a per
share exercise price of $1.50 per share.

   Allan Leinwand. On February 3, 1997, Allan Leinwand, our vice president of
engineering and chief technology officer, entered into an employment agreement
with Digital Island. This agreement provided for an annual salary of $105,000.
Mr. Leinwand is also eligible for a discretionary quarterly bonus of up to
$10,000. Should we terminate Mr. Leinwand for any lawful reason, we must pay
Mr. Leinwand a severance payment equal to one hundred percent of his then
current annual base salary. Currently, Mr. Leinwand's annual salary is
$170,000, and he is eligible for a discretionary quarterly bonus of up to
$12,500. In connection with his employment agreement, we granted to Mr.
Leinwand options to purchase up to 240,000 shares of our common stock at a per
share exercise price of $0.40 per share.

   Tim Wilson. On March 16, 1998, Tim Wilson, our vice president of marketing
and international sales, entered into an employment agreement with Digital
Island. This agreement provided for an annual salary of $150,000. Mr. Wilson is
also eligible for a discretionary quarterly bonus of up to $12,500. On March 1,
1999, Mr. Wilson's annual salary was increased to $165,000 and his
discretionary quarterly bonus was increased to $15,000. In connection with his
employment agreement, we granted Mr. Wilson options to purchase up to 140,000
shares of our common stock at a per share exercise price of $0.90 per share.

   Paul Evenson. On October 26, 1998, Paul Evenson, our vice president of
operations, entered into an employment agreement with Digital Island. This
agreement provided for an annual salary of $165,000. Mr. Evenson is also
eligible for a discretionary quarterly bonus of up to $10,000. In connection
with his employment agreement, we granted Mr. Evenson options to purchase up to
150,000 shares of our common stock at a per share exercise price of $3.50 per
share.

Limitation of Liability and Indemnification

   Our certificate of incorporation eliminates, to the fullest extent permitted
by Delaware law, liability of a director to us or our stockholders for monetary
damages for conduct as a director. Although liability for monetary damages has
been eliminated, equitable remedies such as injunctive relief or rescission
remain available. In addition, a director is not relieved of his or her
responsibilities under any other law, including the federal securities laws.

   Our certificate of incorporation requires us to indemnify our directors to
the fullest extent permitted by Delaware law. We has also entered into
indemnification agreements with each of our directors. We believe that the
limitation of liability provisions in our certificate of incorporation and
indemnification agreements may enhance our ability to attract and retain
qualified individuals to serve as directors. See "Description of Capital
Stock."

Item 12. Security Ownership of Certain Beneficial Owners and Management

   The following table sets forth certain information as of September 30, 1999
(except as indicated in the footnotes below) with respect to the beneficial
ownership of our common stock by:

  . each person known by us to own beneficially more than 5%, in the
    aggregate, of the outstanding shares of our common stock,

                                       49
<PAGE>

  . the directors and named executive officers of Digital Island who hold
    securities of Digital Island, and

  . all executive officers and directors of Digital Island as a group.

   Unless otherwise indicated, the address for each shareholder is c/o Digital
Island, Inc., 45 Fremont, Suite 1200, San Francisco, California 94105. Except
as indicated by footnote, Digital Island understands that the persons named in
the table below have sole voting and investment power with respect to all
shares shown as beneficially owned by them, subject to community property laws
where applicable. In the table below, "Beneficial Ownership of Shares After the
Merger" reflects the beneficial ownership after giving effect to the additional
shares of Digital Island common stock to be issued to Sandpiper shareholders in
the pending Sandpiper merger, which is 24,573,160 shares. Shares of Digital
Island common stock subject to options, which are currently exercisable or
exercisable within 60 days of September 30, 1999, are deemed outstanding for
computing the percentages of the person holding such options but are not deemed
outstanding for computing the percentages of any other person. Percentage
ownership is based on 35,941,727 shares of Digital Island common stock
outstanding as of September 30, 1999.

<TABLE>
<CAPTION>
                                              Beneficial        Beneficial
                                             Ownership of      Ownership of
                                           Shares Before the Shares After the
                                                Merger            Merger
                                           ----------------- -----------------
         Name of Beneficial Owner           Number   Percent  Number   Percent
         ------------------------          --------- ------- --------- -------
<S>                                        <C>       <C>     <C>       <C>
Crosspoint Venture Partners(1)............ 3,246,679   9.0%  3,246,679   5.4%
Chase Venture Capital Associates,
 L.P.(2).................................. 2,823,529   7.9%  2,823,529   4.7%
Vanguard V, L.P.(3)....................... 2,561,310   7.1%  2,561,310   4.2%
Crescendo Ventures II, L.P.(4)............ 2,109,212   5.9%  2,109,212   3.5%
E*TRADE Group, Inc.(5).................... 2,013,367   5.6%  2,013,367   3.3%
Tudor Global Trading, Inc.(6)............. 1,966,724   5.5%  1,966,724   3.3%
FW Ventures III, LP(7).................... 1,882,353   5.2%  1,882,353   3.1%
Merrill Lynch KECALP(8)................... 1,482,824   4.1%  1,482,824   2.5%
Ron Higgins(9)............................ 2,116,666   5.9%  2,116,666   3.5%
Ruann F. Ernst(10)........................   641,032   1.8%    641,032   1.1%
T. L. Thompson............................       --    --          --    --
Paul Evenson(11)..........................    40,353     *      40,353     *
Allan Leinwand(12)........................   186,899     *     186,899     *
Rick Schultz..............................       --    --          --    --
Michael T. Sullivan(13)...................    95,000     *      95,000     *
Tim Wilson(14)............................   112,664     *     112,664     *
Chris Albinson............................       --    --          --    --
Charlie Bass(15)..........................   419,283   1.2%    419,283     *
Marcelo A. Gumucio(16)....................   212,000     *     212,000     *
Christos Cotsakos(17).....................    45,532     *      45,532     *
Cliff Higgerson(18).......................       --    --          --    --
Shahan Soghikian(19)......................       --    --          --    --
David Spreng(20)..........................       --    --          --    --
All directors and executive officers as a
 group (14 people)(21).................... 3,869,429  10.6%  3,869,429   6.4%
</TABLE>

                                       50
<PAGE>

--------
 * Less than 1%.
 (1) Consists of 1,450,000 shares of Digital Island common stock held directly
     by Crosspoint Venture Partners, 869,855 shares of common stock held
     directly by Crosspoint Venture Partners 1996 and 926,824 shares of common
     stock held directly by Crosspoint Venture Partners LS 1997 (collectively,
     with Crosspoint Venture Partners 1996 and Crosspoint Venture Partners, the
     "Crosspoint Entities"). The address for the Crosspoint Entities is 2925
     Woodside Road, Woodside, California 94062.
 (2) Consists of 2,823,529 shares of Digital Island common stock. Mr.
     Soghikian, a director of Digital Island, is the general partner of Chase
     Capital Partners, the general partner of Chase Venture Capital Associates,
     L.P. The address for Chase Venture Capital Associates, L.P. is 50
     California Street, Suite 2940, San Francisco, California 94111.
 (3) Consists of 2,561,310 shares of Digital Island common stock. Mr.
     Higgerson, a director of Digital Island, is the general partner of
     Vanguard V, L.P. The address of Vanguard V, L.P. is 505 Hamilton Avenue,
     Suite 305, Palo Alto, California 94301.
 (4) Consists of 2,109,212 shares of Digital Island common stock held directly
     by Eagle Ventures II, LLC and Crescendo II, L.P., (collectively, the
     "Crescendo Entities"). Mr. Spreng, a director of Digital Island, is the
     president of Eagle Ventures II, LLC and the managing member of Crescendo
     Ventures II, LLC, the general partner of Crescendo II, LP. The address for
     the Crescendo Entities is 505 Hamilton Avenue, Suite 315, Palo Alto,
     California 94301.
 (5) Consists of 2,013,367 shares of Digital Island common stock. Mr. Cotsakos,
     a director of Digital Island, is chairman of the board and chief executive
     officer of E*TRADE Group, Inc. The address of E*TRADE Group, Inc. is Four
     Embarcadero Place, 2400 Geng Road, Palo Alto, California 94303.
 (6) Consists of 1,966,724 shares of Digital Island common stock held directly
     by Raptor Global Fund L.P., Raptor Global Fund Ltd. and Tudor Private
     Equity Fund L.P., (collectively, the "Tudor Entities"). The address for
     the Tudor Entities is Tudor Global Trading, Inc., 40 Rowes Wharf, Second
     Floor, Boston, Massachusetts 02110.
 (7) Consists of 1,882,353 shares of Digital Island common stock The address of
     FW Ventures III, LP is 2775 Sand Hill Road, Menlo Park, California 94025.
 (8) Consists of 1,482,824 shares of Digital Island common stock held directly
     by KECALP, Inc., KECALP Inc., as Nominee for Merrill Lynch KECALP
     International L.P. 1997 and Merrill Lynch KECALP L.P. 1997, (collectively,
     the "Merrill Lynch KECALP Entities"). The address for the Merrill Lynch
     KECALP Entities is World Financial Center, North Tower, New York, NY
     10281.
 (9) Consists of 1,666,000 shares of Digital Island common stock held directly
     by Mr. Higgins, 50,666 shares of Digital Island common stock subject to
     options exercisable within 60 days of September 30, 1999, 150,000 shares
     of Digital Island common stock held directly by the Ron and Sanne Higgins
     1998 Irrevocable Trust Agreement f/b/o Dana Espinoza (the "Espinoza
     Trust"), 150,000 shares of Digital Island common stock held directly by
     the Ron and Sanne Higgins 1998 Irrevocable Trust Agreement f/b/o Nina
     Higgins (the "Higgins Trust") and 100,000 shares of Digital Island common
     stock held by the Ron and Sanne Higgins 1998 Irrevocable Grandchildren's
     Trust Agreement (the "Grandchildren's Trust"). Mr. Higgins is a trustee of
     the Espinoza Trust, the Higgins Trust and the Grandchildren's Trust.
(10) Consists of 233,332 shares of Digital Island common stock held directly by
     Ms. Ernst and 407,700 shares of Digital Island common stock subject to
     options exercisable within 60 days of September 30, 1999.
(11) Consists of 40,353 shares of Digital Island common stock subject to
     options exercisable within 60 days of September 30, 1999.
(12) Consists of 163,733 shares of Digital Island common stock held directly by
     Mr. Leinwand, and 23,166 shares of Digital Island common stock subject to
     options exercisable within 60 days of September 30, 1999.
(13) Consists of 71,000 shares of Digital Island common stock held directly by
     Mr. Sullivan and 24,000 shares of Digital Island common stock subject to
     options exercisable within 60 days of September 30, 1999.
(14) Consists of 53,249 shares of Digital Island common stock held directly by
     Mr. Wilson, and 59,415 shares of Digital Island common stock subject to
     options exercisable within 60 days of September 30, 1999.

                                       51
<PAGE>

(15) Consists of 419,283 shares of Digital Island common stock held directly by
     the Bass Trust U/D/T dated April 29, 1988 (the "Bass Trust"). Mr. Bass, a
     director of Digital Island, is the Trustee of the Bass Trust. Shares after
     the merger excludes shares of Sandpiper.
(16) Consists of 212,000 shares of Digital Island common stock.
(17) Consists of 8,888 shares of Digital Island common stock subject to options
     exercisable within 60 days of September 30, 1999 and 36,644 shares of
     Digital Island common stock held directly by The Cotsakos Revocable Trust
     dated September 3, 1987. Excludes 2,013,367 shares of Digital Island
     common stock held by E*TRADE Group, Inc. Mr. Cotsakos, a director of
     Digital Island, is the Trustee of the Cotsakos Trust and chairman of the
     board and chief executive officer of E*TRADE Group, Inc. Mr. Cotsakos
     disclaims beneficial ownership of the shares of Digital Island common
     stock held by E*TRADE Group, Inc. except to the extent of his pecuniary
     interest therein. See footnote 5 above.
(18) Excludes 2,561,310 shares of Digital Island common stock held by Vanguard
     V, L.P. Mr. Higgerson, a director of Digital Island, is the general
     partner of Vanguard V, L.P. Mr. Higgerson disclaims beneficial ownership
     of the shares of Digital Island common stock held by Vanguard V, L.P.
     except to the extent of his pecuniary interest therein. See footnote 3
     above.
(19) Excludes 2,823,529 shares of Digital Island common stock held by Chase
     Venture Capital Associates, L.P. Mr. Soghikian, a director of Digital
     Island, is the general partner of Chase Capital Partners, the general
     partner of Chase Venture Capital Associates, L.P. Mr. Soghikian disclaims
     beneficial ownership of the shares of Digital Island common stock held by
     Chase Venture Capital Associates, L.P. except to the extent of his
     pecuniary interest therein. See footnote 2 above.
(20) Excludes 2,109,212 shares of Digital Island common stock held by the
     Crescendo Entities. Mr. Spreng, a director of Digital Island, is the
     president of Eagle Ventures II, LLC and the managing member of Crescendo
     Ventures II, LLC, the general partner of Crescendo. Mr. Spreng disclaims
     beneficial ownership of the shares of Digital Island common stock held by
     the Crescendo Entities, except to the extent of his pecuniary interest
     therein. See footnote 4 above.
(21) See footnotes 9 through 19 above. Includes options exercisable for 563,522
     shares of Digital Island common stock within 60 days of September 30, 1999
     under the 1999 stock incentive plan.

                                       52
<PAGE>

Item 13. Certain Relationships and Related Transactions

   Some of our directors, executive officers and affiliates have entered into
transactions with it as follows:

Preferred Stock Financings

   Since October 1, 1997 we have sold 4,283,181 shares of our Series C
preferred stock at a price of $3.45 per share, 2,022,476 shares of our Series
D preferred stock at a price of $5.25 per share and 11,764,706 shares of our
Series E preferred stock at a price of $4.25 per share in a series of private
financings. We sold these securities pursuant to preferred stock purchase
agreements and an investors' rights agreement on substantially similar terms
(except for terms relating to date and price), under which we made standard
representations, warranties, and covenants, and pursuant to which we provided
the purchasers thereunder with registration rights, information rights, and
rights of first refusal, among other provisions standard in venture capital
financings. Each share of preferred stock automatically converted into one
share of our common stock at our initial public offering, except that each
share of Series D preferred stock converted into 1.088084 shares of our common
stock after giving effect to an antidilution adjustment resulting from the
sale of the Series E preferred stock. The purchasers of the preferred stock
included, among others, the following holders of 5% or more of our common
stock, directors, and entities associated with directors:

<TABLE>
<CAPTION>
                                          Shares of Preferred Stock
                                                  Purchased
                                        -----------------------------------
                 Name                   Series C     Series D     Series E
                 ----                   ---------    ---------    ---------
<S>                                     <C>          <C>          <C>
Bass Trust U/D/T dated April 29,
 1988(1)...............................    39,420       34,095       27,765
Chase Venture Capital Associates,
 L.P.(2)...............................       --           --     2,823,529
The Cotsakos Revocable Trust dated
 9/3/87(3).............................       --        28,571          --
Crescendo II, L.P.(4)..................   289,855(5)   143,429(5)   463,294(5)
Crosspoint Venture Partners............   289,855          --       926,824
E*TRADE Group, Inc.(6).................       --     1,333,334      562,588
FW Ventures III, L.P...................       --           --     1,822,353
Marcelo Gumucio........................    29,000          --           --
Merrill Lynch KECALP...................       --           --     1,482,824
Tudor Global Trading, Inc.............. 1,015,000      190,476      744,470
Vanguard V, L.P.(7)....................   260,870      142,857          --
</TABLE>
--------
(1) Charlie Bass, a director of Digital Island, is the trustee of the Bass
    Trust U/D/T dated April 29, 1998.
(2) Shahan Soghikian, a director of Digital Island, is a general partner of
    Chase Venture Capital Associates, L.P.
(3) Christos Cotsakos, a director of Digital Island, is the trustee of The
    Cotsakos Revocable Trust dated 9/3/87.
(4) David Spreng, a director of Digital Island, is the managing member of
    Crescendo Ventures II, LLC, the general partner of Crescendo II, L.P.
(5) Includes shares held by Eagle Ventures II, LLC pursuant to a parallel
    investment agreement with Crescendo.
(6) Mr. Cotsakos, a director of Digital Island, is chairman of the board of
    E*TRADE.
(7) Cliff Higgerson, a director of Digital Island, is the general partner of
    Vanguard V, L.P.

                                      53
<PAGE>

Investors' Rights Agreement

   Pursuant to the terms of the Amended and Restated Investors' Rights
Agreement dated February 19, 1999, as amended, by and among Digital Island and
the holders of our preferred stock, the investors acquired certain registration
rights with respect to their capital stock of Digital Island. At any time after
the earlier of (a) February 19, 2001, or (b) one year after our initial public
offering, holders of more than two-thirds of the outstanding stock under the
agreement may require us to effect registration under the Securities Act
covering the lesser of 50% of the outstanding Registrable Securities (as
defined in the Investors' Rights Agreement) or a number of shares of common
stock yielding gross aggregate proceeds in excess of $15.0 million, subject in
either case to the board of directors' right if such registration would harm
Digital Island to defer such registration for a period up to 60 days. In
addition, if we propose to issue equity securities under the Securities Act for
our own account in an underwritten public offering, then any of the investors
has a right (subject to quantity limitations determined by the underwriters) to
request that Digital Island register such investor's Registrable Securities.
All registration expenses incurred in connection with the first two demand
registrations described above and all piggyback registrations will be borne by
Digital Island. The participating investors will pay for underwriting discounts
and commissions incurred in connection with any such registrations. We have
agreed to indemnify the investors against certain liabilities in connection
with any registration effected pursuant to the foregoing Investors' Rights
Agreement, including Securities Act liabilities.

Employment and Indemnification Agreements

   We have entered into employment agreements with Ms. Ernst, Mr. Leinwand, Mr.
Wilson and Mr. Evenson who are named executive officers. We have also entered
into indemnification agreements with each of our other directors and officers.
See "Executive Compensation and Other Information--Employment Contracts and
Change of Control Arrangements," and "--Limitation of Liability and
Indemnification."

Director Arrangements and Stockholder Notes

   In February 1998, we granted a nonstatutory option to purchase a total of
183,000 shares of our common stock to Marcelo Gumucio, then the chairman of the
our board of directors and now a director. These options were immediately
exercisable and subject to repurchase by Digital Island, with the right to
repurchase expiring in 16 equal quarterly installments. At the time of the
option grant, Mr. Gumucio exercised the option to purchase the entire 183,000
shares of common stock, in exchange for a $109,800 note. Under the terms of the
note, interest accrued on outstanding amounts at 5.61% per annum. Interest was
to be repaid in four equal annual installments commencing February 24, 1999.
The entire principal amount was due and payable in one lump sum on February 24,
2002. In August 1999, Mr. Gumucio repaid the entire principal amount as well as
all accrued interest.

Officer Loans

   On April 21, 1999, Ms. Ernst, our president and chief executive officer, and
Mr. Higgins, our then-chairman of the board, each delivered a promissory note
to us in payment of the exercise price of certain outstanding stock options
they hold under our 1998 stock option/stock issuance plan. Ms. Ernst delivered
a full-recourse promissory note in the principal amount of $199,998 in payment
of the exercise price for 133,332 shares of our common stock, and Mr. Higgins
delivered a full-recourse promissory note in the amount of $86,400 in payment
of the exercise price for 216,000 shares of our common stock. Each note bears
interest at the rate of 7.75% per annum, compounded semi-annually, and is
secured by the purchased shares. Accrued interest is due and payable at
successive quarterly intervals over the four-year term of the note, and the
principal balance will become due and payable in one lump sum at the end of
such four-year term. However, the entire unpaid balance of the note will become
due and payable upon termination of employment or failure to pay any
installment of interest when due. None of the shares serving as security for
the note may be sold unless the principal portion of the note attributable to
those shares, together with the accrued interest on that principal portion, is
paid to us.

                                       54
<PAGE>

   On June 14, 1999, Ms. Ernst borrowed an additional $128,000 from us in order
to finance the tax liability she incurred in connection with the exercise of
her stock options on April 21, 1999 for 133,332 shares of our common stock. The
loan is evidenced by a full-recourse promissory note with interest at the rate
of 7.75% per annum, compounded semi-annually, and secured by the same 133,332
shares which serve as collateral for Ms. Ernst's April 21, 1999 promissory
note. The terms of her note, including the due dates for payment of principal
and accrued interest and the acceleration provisions, are substantially the
same as the terms in effect for her April 21, 1999 note.

   On July 13, 1999 Chris Albinson, our vice president of corporate
development, borrowed $100,000 from us. The borrowing is interest-free, and
$50,000 of the borrowings is being forgiven ratably over five years. The
remaining $50,000 is due in one lump sum on July 13, 2004.

E*TRADE Agreements

   We have entered into a global data distribution agreement with E*TRADE dated
August 1, 1997 where we provide network connectivity for E*TRADE. Mr. Costakos,
a member of our board of directors, is president, chief executive officer and a
director of E*TRADE.

   We believe that all of the transactions set forth above were made on terms
no less favorable to us than could have been obtained from unaffiliated third
parties. We intend that all future transactions, including loans, between us
and our officers, directors, principal stockholders and their affiliates will
be approved by a majority of the board of directors, and be on terms no less
favorable to us than could be obtained from unaffiliated third parties.

                                       55
<PAGE>

                                    PART IV

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

(a) The following documents are filed as a part of this Report:

<TABLE>
<CAPTION>
                                                                             Page
                                                                             ----
   1. Financial Statements.

 <C> <S>                                                                     <C>
      Independent Auditor's Report.......................................    F-2
      Consolidated Balance Sheets--As of September 30, 1999 and 1998.....    F-3
      Consolidated Statements of Operations--For the Three Year Period
      Ended September 30, 1999...........................................    F-4
      Consolidated Statements of Stockholders' Equity--For the Three Year
      Period Ended September 30,
       1999..............................................................    F-5
      Consolidated Statements of Cash Flows--For the Three Year Period
      Ended September 30, 1999...........................................    F-6
      Notes to Consolidated Financial Statements.........................    F-7

   2. Financial Statement Schedule. The following Financial Statement Schedule
   of the Registrant is filed as part of this report:

      Schedule II--Valuation and Qualifying Accounts.....................    S-2
</TABLE>

   All other schedules are omitted because they are not applicable or the
required information is shown in the Consolidated Financial Statements or
notes thereto.

   3. Exhibits. The following Exhibits are filed as part of, or incorporated
by reference into, this report:

<TABLE>
<CAPTION>
 Exhibit
 Number                              Exhibit Title
 -------                             -------------
 <C>     <S>
  2.1    Agreement and Plan of Reorganization dated as of October 24, 1999, by
         and among the Registrant, Beach Acquisition Corp. and Sandpiper
         Networks, Inc. (attached as Annex A to the joint proxy/prospectus
         contained in the Registration Statement on Form S-4 as filed as
         Exhibit 99.1 herewith)
  3.1*   Registrant's Amended and Restated Certificate of Incorporation
  3.2*   Registrant's Amended and Restated Bylaws
  4.1*   Specimen Stock Certificate
  4.2*   Amended and Restated Investors' Rights Agreement among the Registrant
         and the parties listed on the signature pages thereto dated as of
         February 19, 1999
  4.3*   Registrant's Amended and Restated Certificate of Incorporation (See
         Exhibit 3.1)
  4.4*   Registrant's Amended and Restated Bylaws (See Exhibit 3.2)
         Amendment No. 1 to the Amended and Restated Investors' Rights
  4.5*   Agreement, dated April 9, 1999
 10.1*   1997 Stock Option Agreement
 10.2*   1998 Stock Option/Stock Issuance Agreement
 10.3*   1999 Stock Incentive Plan
 10.4*   1999 Employee Stock Purchase Plan
 10.5*   Form of Indemnification Agreement for Officers and Directors
 10.6*   Employment Agreement between the Registrant and Ruann F. Ernst
 10.7*   Employment Agreement between the Registrant and Allan Leinwand
 10.8*   Employment Agreement between the Registrant and Timothy M. Wilson
 10.9*   Employment Agreement between the Registrant and Paul Evenson
 10.10*  Employment Agreement between the Registrant and Leo S. Spiegel
</TABLE>

                                      56
<PAGE>

<TABLE>
<CAPTION>
Exhibit
Number                                             Exhibit Title
-------                                            -------------
<S>      <C>
10.11*   Employment Agreement between the Registrant and Andrew Swart
10.12*   Employment Agreement between the Registrant and David Farber
10.13*    Lease between the Registrant and Bishop Street Associates, dated October 21, 1996, as amended to
          date
10.14*   Lease agreement between the Registrant and Forty-Five Fremont Associates, dated May 5, 1999
10.15*   Note Secured by Stock Pledge Agreement by Ruann F. Ernst to Registrant, dated April 21, 1999
21.1*    Subsidiaries of Registrant
23.1     Consent of Independent Auditors
24.1     Power of Attorney (see signature page to this Form 10-K)
27.1     Financial Data Schedule
99.1     Registration Statement on Form S-4, filed with the Commission on December 9, 1999
</TABLE>
--------
*  Incorporated by reference to the corresponding Exhibit of the Registrant's
   Registration Statement on Form S-4 (File No. 333-92393), filed on December
   9, 1999.

(b) The Registrant did not file or amend reports on Form 8-K during the last
    quarter of the fiscal year ended September 30, 1999.

(c) See the Exhibit Index of this Form 10-K.

                                       57
<PAGE>

                                   SIGNATURES

   Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.

Date: December 27, 1999                   Digital Island, Inc.

                                                     /s/ Ruann F. Ernst
                                          By: _________________________________
                                                      Ruann F. Ernst,
                                                  Chief Executive Officer
                                               (Principal Executive Officer)

                               POWER OF ATTORNEY

   KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Ruann F. Ernst and T.L. Thompson, and each of
them, his or her true and lawful attorneys-in-fact, each with full power of
substitution, for him or her in any and all capacities, to sign any amendments
to this report on Form 10-K and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said attorneys-in-
fact or their substitute or substitutes may do or cause to be done by virtue
hereof.

   Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:

<TABLE>
<CAPTION>
              Signature                          Title                   Date
              ---------                          -----                   ----


<S>                                    <C>                        <C>
       /s/ Ruann F. Ernst              Chief Executive Officer     December 27, 1999
______________________________________  and Director (Principal
            Ruann F. Ernst              Executive Officer)


        /s/ T.L. Thompson              Chief Financial Officer     December 27, 1999
 ______________________________________
            T.L. Thompson

        /s/ Charlie Bass               Director                    December 27, 1999
 ______________________________________
             Charlie Bass

      /s/ Christos Cotsakos            Director                    December 27, 1999
 ______________________________________
          Christos Cotsakos

     /s/ Marcelo A. Gumucio            Director                    December 27, 1999
 ______________________________________
          Marcelo A. Gumucio

       /s/ Cliff Higgerson             Director                    December 27, 1999
 ______________________________________
           Cliff Higgerson

        /s/ David Spreng               Director                    December 27, 1999
 ______________________________________
             David Spreng

      /s/ Shahan Soghikian             Director                    December 27, 1999
______________________________________
           Shahan Soghikian
</TABLE>

                                       58
<PAGE>

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

               INDEX TO DIGITAL ISLAND, INC. FINANCIAL STATEMENTS

<TABLE>
<S>                                                                          <C>
Report of Digital Island, Inc. Independent Accountants...................... F-2
Consolidated Balance Sheets................................................. F-3
Consolidated Statements of Operations....................................... F-4
Consolidated Statements of Stockholders' Equity............................. F-5
Consolidated Statements of Cash Flows....................................... F-6
Notes to Consolidated Financial Statements.................................. F-7
</TABLE>

                                      F-1
<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of
Digital Island, Inc. and Subsidiaries:

   In our opinion, the accompanying balance sheets and the related statements
of operations, stockholders' equity and cash flows present fairly, in all
material respects, the financial position of Digital Island, Inc. and
Subsidiaries (the Company) at September 30, 1999 and 1998, and the results of
its operations and its cash flows for each of the three years in the period
ended September 30, 1999, in conformity with generally accepted accounting
principles. 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 generally accepted auditing standards 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 the opinion expressed above.

                                          /s/ PricewaterhouseCoopers LLP

San Francisco, California
October 29, 1999, except as to Note 16, which is as of
December 8, 1999

                                      F-2
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

                          CONSOLIDATED BALANCE SHEETS
                       (In thousands, except share data)

<TABLE>
<CAPTION>
                                                               September 30,
                                                              -----------------
                                                               1998      1999
                                                              -------  --------
<S>                                                           <C>      <C>
                           ASSETS
                           ------
Current assets:
  Cash and cash equivalents.................................  $ 5,711  $ 43,315
  Investments...............................................   10,123    31,691
  Accounts receivable, net of allowance of $55 and $380
   respectively.............................................      662     3,557
  Restricted cash...........................................      263       763
  Loan receivable...........................................      532       --
  Deferred offering costs...................................      132       --
  Prepaid expenses and other................................      152     1,825
                                                              -------  --------
     Total current assets...................................   17,575    81,151
Property and equipment, net.................................    4,938    25,273
Other assets................................................      104     1,224
                                                              -------  --------
     Total assets...........................................  $22,617  $107,648
                                                              =======  ========
            LIABILITIES AND STOCKHOLDERS' EQUITY
            ------------------------------------

Current liabilities:
  Bank borrowings...........................................  $   801  $    801
  Capital lease obligations.................................      756     3,916
  Accounts payable..........................................    2,408     8,621
  Accrued liabilities.......................................      716     4,931
  Cash overdraft............................................      --      3,058
  Deferred revenue..........................................       11       318
                                                              -------  --------
     Total current liabilities..............................    4,692    21,645
Bank borrowings, less current portion.......................      884       314
Capital lease obligations, less current portion.............    1,551     6,061
Deferred revenue............................................      --        410
                                                              -------  --------
     Total liabilities......................................    7,127    28,430
                                                              =======  ========
Commitments (Note 8)
Stockholders' equity:
  Series A through E convertible preferred stock, $0.001 par
   value: Authorized: 14,000,000 shares in 1998 and no
   shares in 1999; issued and outstanding: 13,305,657 shares
   in 1998 and no shares in 1999............................       13       --
  Preferred stock, $0.001 par value:
   Authorized: no shares in 1998 and 10,000,000 shares in
    1999; no shares issued and outstanding..................      --        --
  Common stock, $0.001 par value:
   Authorized: 30,000,000 shares in 1998, and 100,000,000
    shares in 1999; issued and outstanding: 2,519,835 shares
    in 1998 and 35,941,727 shares in 1999...................        3        36
   Additional paid-in capital...............................   39,182   156,791
   Deferred compensation....................................   (1,503)   (4,033)
   Stockholder note receivable..............................     (110)     (514)
   Common stock warrants....................................       29       --
   Accumulated deficit......................................  (22,124)  (73,062)
                                                              -------  --------
     Total stockholders' equity.............................   15,490    79,218
                                                              -------  --------
     Total liabilities and stockholders' equity.............  $22,617  $107,648
                                                              =======  ========
</TABLE>

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

                                      F-3
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

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

<TABLE>
<CAPTION>
                                                Year Ended September 30,
                                             ---------------------------------
                                               1997        1998        1999
                                             ---------  ----------  ----------
<S>                                          <C>        <C>         <C>
Revenue....................................  $     218  $    2,343  $   12,431
Costs and expenses:
  Cost of revenue..........................      2,508       9,039      29,496
  Sales and marketing......................      1,205       4,847      16,010
  Product development......................        378       1,694       6,357
  General and administrative...............      1,502       3,392       9,848
  Stock compensation expense...............        --          487       3,207
                                             ---------  ----------  ----------
  Total costs and expenses.................      5,593      19,459      64,918
                                             ---------  ----------  ----------
  Loss from operations.....................     (5,375)    (17,116)    (52,487)
                                             ---------  ----------  ----------
Interest income, net.......................         87         354       1,551
                                             ---------  ----------  ----------
  Loss before income taxes.................     (5,288)    (16,762)    (50,936)
Provision for income taxes.................          1           2           2
                                             ---------  ----------  ----------
  Net loss.................................  $  (5,289) $  (16,764) $  (50,938)
                                             =========  ==========  ==========
Basic and diluted net loss per share.......  $   (3.53) $    (7.50) $    (4.58)
                                             =========  ==========  ==========
Weighted average shares outstanding used in
 per share calculation.....................  1,497,711   2,236,452  11,127,462
                                             =========  ==========  ==========
Pro forma basic and diluted net loss per
 share.....................................             $    (1.39) $    (2.02)
                                                        ==========  ==========
Weighted average shares outstanding used in
 pro forma per share calculation...........             12,042,539  25,233,080
                                                        ==========  ==========
</TABLE>


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

                                      F-4
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                (In thousands)

<TABLE>
<CAPTION>
                     Convertible
                      Preferred
                        Stock       Common Stock   Additional              Stockholder  Common                 Total
                    --------------- --------------  Paid-in     Deferred      Note      Stock   Accumulated Stockholders
                    Shares   Amount Shares  Amount  Capital   Compensation Receivable  Warrants   Deficit      Equity
                    -------  ------ ------  ------ ---------- ------------ ----------- -------- ----------- ------------
<S>                 <C>      <C>    <C>     <C>    <C>        <C>          <C>         <C>      <C>         <C>
Balances,
September 30,
1996..............    2,000   $  2     275   $ --   $    129    $   --        $ --       $ 23    $    (71)    $     83
Common stock
issued for
professional
services..........      --      --      71     --         28        --          --         --         --            28
Conversion of
preferred stock
into common
stock.............   (2,000)    (2)  2,000      2        --         --          --         --         --           --
Repurchase of
common stock......      --      --    (130)    --         (1)       --          --         --         --            (1)
Series A preferred
stock issued for
cash, net of
issuance costs of
$17...............    3,342      3     --      --      3,322        --          --         --         --         3,325
Series B preferred
stock issued for
cash, net of
issuance costs of
$46...............    3,000      3     --      --      7,451        --          --         --         --         7,454
Warrants issued in
connection with
convertible note..      --      --     --      --        --         --          --          6         --             6
Conversion of
notes payable into
Series A preferred
Stock.............      658      1     --      --        657        --          --         --         --           658
Net loss..........      --      --     --      --        --         --          --         --      (5,289)      (5,289)
                    -------   ----  ------   ----   --------    -------       -----      ----    --------     --------
Balances,
September 30,
1997..............    7,000      7   2,216      2     11,586        --          --         29      (5,360)       6,264
Series C preferred
stock issued for
cash, net of
issuance costs of
$34...............    4,283      4     --      --     14,739        --          --         --         --        14,743
Series D preferred
stock issued for
cash, net of
issuance costs of
$33...............    2,023      2     --      --     10,583        --          --         --         --        10,585
Issuance of
stockholder note
in exchange for
common Stock......      --      --     183      1        110        --         (110)       --         --             1
Common stock
issued for
professional
services..........      --      --       6     --         18        --          --         --         --            18
Common stock
issued for cash
upon exercise of
options...........      --      --     115     --        156        --          --         --         --           156
Deferred
compensation in
connection with
issuance of stock
options...........      --      --     --      --      1,990     (1,990)        --         --         --           --
Amortization of
deferred
compensation......      --      --     --      --        --         487         --         --         --           487
Net loss..........      --      --     --      --        --         --          --         --     (16,764)     (16,764)
                    -------   ----  ------   ----   --------    -------       -----      ----    --------     --------
Balances,
September 30,
1998..............   13,306     13   2,520      3     39,182     (1,503)       (110)       29     (22,124)      15,490
Series E preferred
stock issued for
cash, net of
issuance costs of
$2,539............   11,765     12     --      --     47,450        --          --         --         --        47,462
Common stock
issued for cash
upon exercise of
options...........      --      --     829      1        964        --          --         --         --           965
Deferred
compensation in
connection with
issuance of stock
options...........      --      --     --      --      5,737     (5,737)        --         --         --           --
Amortization of
deferred
compensation......      --      --     --      --        --       3,207         --         --         --         3,207
Issuance of
stockholder note
in exchange for
common stock......      --      --     349     --        286        --         (286)       --         --           --
Common stock
issued for cash
upon exercise of
warrants..........      --      --      95     --         38        --          --        (29)        --             9
Additional shares
of Series D
preferred stock
issued upon
Conversion........      178     --     --      --        --         --          --         --         --           --
Conversion of
preferred stock...  (25,249)   (25) 25,249     25        --         --          --         --         --           --
Issuance of common
stock in public
offering, net of
issuance costs of
$5,858............      --      --   6,900      7     63,134        --          --         --         --        63,141
Notes issued to
officers in
exchange for
cash..............      --      --     --      --        --         --         (228)       --         --          (228)
Repayment of
stockholder note..      --      --     --      --        --         --          110        --         --           110
Net loss..........      --      --     --      --        --         --          --         --     (50,938)     (50,938)
                    -------   ----  ------   ----   --------    -------       -----      ----    --------     --------
Balances,
September 30,
1999..............      --    $ --  35,942   $ 36   $156,791    $(4,033)      $(514)     $ --    $(73,062)    $ 79,218
                    =======   ====  ======   ====   ========    =======       =====      ====    ========     ========
</TABLE>

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

                                      F-5
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (In thousands)

<TABLE>
<CAPTION>
                                                    Year Ended September 30,
                                                    ---------------------------
                                                     1997      1998      1999
                                                    -------  --------  --------
<S>                                                 <C>      <C>       <C>
Cash flows from operating activities:
 Net loss.........................................  $(5,289) $(16,764) $(50,938)
 Adjustments to reconcile net loss to net cash
  used in operating activities:
   Depreciation and amortization..................      158       547     1,735
   Amortization of capital lease obligations......      --        263     1,507
   Stock compensation expense.....................      --        487     3,207
   Non-cash revenue in connection with barter
    agreement.....................................     (132)      --        --
   Debt discount in conjunction with convertible
    notes.........................................       29       --        --
   Amortization of discounts on investments.......      (24)     (227)     (817)
   Professional services in exchange for common
    stock.........................................       28        18       --
   Loss on disposal of property and equipment.....      --          2         5
 Change in operating assets and liabilities:
   Accounts receivable............................      (73)     (589)   (2,895)
   Prepaid expenses and other.....................       27       (98)   (1,673)
   Deferred offering costs........................      --       (132)      132
   Accounts payable...............................    1,901       486     6,213
   Accrued liabilities............................      322       394     4,215
   Deferred revenue...............................        9         2       717
   Other assets...................................      (36)      (68)   (1,138)
                                                    -------  --------  --------
     Net cash used in operating activities........   (3,080)  (15,679)  (39,730)
                                                    -------  --------  --------
Cash flows from investing activities:
 Purchases of property and equipment..............   (2,128)   (1,234)  (14,337)
 Proceeds from maturities of short-term
  investments.....................................    1,000     5,600    31,478
 Decrease (increase) in restricted cash...........     (384)      121      (500)
 Purchases of short-term investments..............   (2,959)  (13,513)  (52,229)
                                                    -------  --------  --------
     Net cash used in investing activities........   (4,471)   (9,026)  (35,588)
                                                    -------  --------  --------
Cash flows from financing activities:
 Proceeds from issuance of preferred stock, net...   10,779    25,328    47,462
 Proceeds from issuance of common stock, net......      --        156    64,115
 Proceeds from issuance of notes payable..........      308       --        --
 Proceeds from bank borrowings....................      705       647       532
 Repayments of bank borrowings....................      --       (199)     (570)
 Repayments of capital lease obligations..........      --       (100)   (1,557)
 Repayment of stockholder note receivable.........      --        --        110
 Issuance of loans to officers....................      --        --       (228)
 Cash overdraft...................................      --        --      3,058
 Repurchase of common stock.......................       (1)      --        --
                                                    -------  --------  --------
     Net cash provided by financing activities....   11,791    25,832   112,922
                                                    -------  --------  --------
     Net increase in cash and cash equivalents....    4,240     1,127    37,604
Cash and cash equivalents, beginning of period....      344     4,584     5,711
                                                    -------  --------  --------
Cash and cash equivalents, end of period..........  $ 4,584  $  5,711  $ 43,315
                                                    =======  ========  ========
Supplemental disclosures of cash flow information:
 Cash paid for interest...........................  $    27  $    129  $    494
                                                    =======  ========  ========
 Cash paid for income taxes.......................  $     2  $      2  $      2
                                                    =======  ========  ========
Supplemental schedule of noncash investing and
 financing activities:
 Common stock issued for professional services....  $    28  $     18  $    --
                                                    =======  ========  ========
 Receivable on bank borrowings....................  $   --   $    532  $    --
                                                    =======  ========  ========
 Notes payable converted into preferred stock.....  $   658  $    --   $    --
                                                    =======  ========  ========
 Conversion of preferred stock into common
  stock...........................................  $    21  $    --   $     25
                                                    =======  ========  ========
 Note receivable issued in exchange for common
  stock...........................................  $   --   $    110  $    286
                                                    =======  ========  ========
 Capital lease obligations for equipment..........  $   --   $  2,406  $  9,227
                                                    =======  ========  ========
 Non-cash compensation expense....................  $   --   $    487  $  3,207
                                                    =======  ========  ========
</TABLE>

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

                                      F-6
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. The Company:

   Digital Island, Inc. and Subsidiaries (the "Company") offers a global
internet protocol applications network designed to deploy business-critical
applications worldwide. The Company also offers services such as network
management and application services to customers deployed on its network.
Together, these services provide a product offering that enables multinational
corporations to reach end users in worldwide local markets.

2. Summary of Significant Accounting Policies:

 Principles of Consolidation:

   The accompanying consolidated financial statements of the Company include
the accounts of Digital Island, Inc. and its wholly-owned subsidiaries, Digital
Island B.V., Digital Island Ltd., Digital Island (Europe) SA, Digital Island
(Hong Kong), Ltd., and Digital Island (Japan) KK, all of which were established
in fiscal 1999. All significant intercompany accounts and transactions are
eliminated in consolidation.

 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 and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

 Revenue Recognition:

   Revenues are comprised primarily of bandwidth charges, equipment co-location
and storage fees, and one-time fees for installation if required to provide
services. Bandwidth charges are billed and recognized monthly based on customer
usage. All other revenues are based on flat-rate monthly charges. Installation
fees are typically recognized at the time that installation occurs. To date,
such revenues have not significantly exceeded the direct costs of installation.

 Computation of Historical Net Loss Per Share and Pro Forma Net Loss Per Share:

   In accordance with SFAS 128, basic earnings per share is computed using the
weighted average number of common shares outstanding during the period. Diluted
earnings per share is computed using the weighted average number of common and
dilutive common equivalent shares outstanding during the period, using either
the as if converted method for convertible preferred stock or the treasury
stock method for options and warrants.

   Diluted net loss per share for the years ended September 30, 1997, 1998 and
1999 does not include the effect of 1,583,500, 2,993,765, and 3,847,569 stock
options, respectively, and 95,000, 95,000, and 0 common stock warrants,
respectively, or 7,000,000, 13,305,657, and 0 shares of convertible preferred
stock on an "as if converted" basis, respectively, as the effect of their
inclusion is antidilutive during each period.

                                      F-7
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   Pro forma basic and diluted net loss per share is presented to reflect per
share data assuming the conversion of all outstanding shares of convertible
preferred stock into common stock as if the conversion had taken place at the
beginning of the fiscal year or at the date of issuance, if later.

 Cash and Cash Equivalents:

   Cash and cash equivalents are stated at cost, which approximates fair value.
The Company includes in cash equivalents all highly liquid investments which
mature within three months of their purchase date.

 Fair Value of Financial Instruments:

   The carrying amounts of certain of the Company's financial instruments
including cash and cash equivalents, accounts receivable, notes payable,
capital leases, accounts payable and accrued liabilities approximate fair value
due to their short maturities.

 Investments:

   At September 30, 1998 and 1999 the Company's investments consisted of
commercial paper. Remaining maturities at the time of purchase are generally
less than one year.

   Investments are accounted for in accordance with Statement of Financial
Accounting Standards No. 115 ("SFAS 115") "Accounting for Certain Investments
in Debt and Equity Securities." This statement requires that securities be
classified as "held to maturity," "available for sale" or "trading," and the
securities in each classification be accounted for at either amortized cost or
fair market value, depending upon their classification. The Company has the
intent and the ability to hold investments until maturity. Therefore, all such
investments are classified as held to maturity investments and carried at
amortized cost in the accompanying consolidated financial statements.

   The Company's investments consist of the following (in thousands):

<TABLE>
<CAPTION>
                                               September 30,     September 30,
                                                   1998              1999
                                             ----------------- -----------------
                                             Amortized  Fair   Amortized  Fair
                                               Cost     Value    Cost     Value
                                             --------- ------- --------- -------
     <S>                                     <C>       <C>     <C>       <C>
     Commercial paper.......................  $10,123  $10,125  $31,691  $31,683
</TABLE>

 Restricted Cash:

   Restricted cash consists of irrevocable standby letters of credit issued by
the Company's banks. Funds are generally held in certificates of deposit at the
Company's bank, and have been established in favor of a third party
beneficiary. The funds are released to the beneficiary in the event that the
Company fails to comply with certain specified contractual obligations.
Provided the Company meets these contractual obligations, the letter of credit
is discharged and the Company is no longer restricted from use of the cash.

 Property and Equipment:

   Property and equipment are recorded at cost and depreciated using the
straight-line method over their useful lives. Equipment recorded under capital
leases is amortized using the straight-line method over the shorter of the
respective lease term or the estimated useful life of the asset. Network and
communications equipment is depreciated over five years, computer equipment and
software is depreciated over three years, and
furniture and fixtures are depreciated over seven years. Maintenance and
repairs are charged to expense as

                                      F-8
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

incurred, and improvements and betterments are capitalized. When assets are
retired or otherwise disposed of, the cost and accumulated depreciation are
removed from the accounts and any resulting gain or loss is reflected in
operations in the period realized.

 Long-lived Assets:

   The Company evaluates the recoverability of its long-lived assets in
accordance with Statement of Financial Accounting Standards No. 121, ("SFAS
121") "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of." SFAS 121 requires recognition of impairment of long-
lived assets in the event the net book value of such assets exceeds the future
undiscounted cash flows attributable to such assets. No such impairments have
been identified to date. The Company assesses the impairment of long-lived
assets when events or changes in circumstances indicate that the carrying value
of an asset may not be recoverable.

 Income Taxes:

   The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standards No. 109, (SFAS 109) "Accounting for Income
Taxes." Under SFAS 109, deferred tax liabilities and assets are determined
based on the difference between the financial statement and tax bases of assets
and liabilities using enacted tax rates in effect for the year in which the
differences are expected to reverse. Valuation allowances are established when
necessary to reduce deferred tax assets to the amounts expected to be realized.
Income tax expense represents the tax payable for the current period and the
change during the period in the deferred tax assets and liabilities.

 Software Development Costs:

   Software development costs have been accounted for in accordance with
Statement of Financial Accounting Standards No. 86, ("SFAS 86") "Accounting for
the Costs of Computer Software to be Sold, Leased or Otherwise Marketed." Under
the standard, capitalization of software development costs begins upon the
establishment of technological feasibility. To date, all such amounts have been
insignificant, and accordingly, the Company has charged all such costs to
research and development expenses.

 Deferred Revenues:

   Deferred revenues primarily represent advanced billings to customers, or
prepayments by customers prior to completion of installation or prior to
provision of contractual bandwidth usage.

 Concentration of Credit Risk:

   Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of temporary cash investments
and accounts receivable. The Company places its temporary investments with one
major financial institution.

   The Company performs ongoing credit evaluations, does not require
collateral, and maintains reserves for potential credit losses on customer
accounts when deemed necessary. For the year ended September 30, 1997, three
customers accounted for approximately 56%, 20%, and 10%, respectively, of all
revenue generated by the Company, and 0%, 57%, and 31% of accounts receivable
at September 30, 1997, respectively. For the year ended September 30, 1998, the
same customers accounted for approximately 13%, 20%, and 4%, respectively,
of all revenue generated by the Company, and 19%, 5%, and 0% of accounts
receivable at September 30, 1998,

                                      F-9
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

respectively. In addition, a fourth customer accounted for 12% of all revenues
generated by the Company for the year ended September 30, 1998, and 14% of
accounts receivable at September 30, 1998. For the year ended September 30,
1999, the same four customers accounted for approximately 4%, 35%, 1%, and 4%,
respectively, of all revenues generated by the Company, and 6%, 41%, 0%, and
3%, respectively, of accounts receivable at September 30, 1999.

 Risks and Uncertainties:

   Factors that may materially and adversely affect the Company's future
operating results include: demand for and market acceptance of the Company's
products and services; introductions of products and services or enhancements
by the Company and its competitors; competitive factors that affect our
pricing; capacity utilization of the Digital Island Global IP applications
network; reliable continuity of service and network availability; the ability
and cost of bandwidth and our ability to increase bandwidth as necessary; the
timing of customer installations; the mix of products and services sold by the
Company; customer retention; the timing and success of marketing efforts and
product and service introductions by the Company; the timing and magnitude of
capital expenditures, including costs relating to the expansion of operations;
the timely expansion of its network infrastructure; fluctuations in bandwidth
used by customers; the retention of key personnel; conditions specific to the
Internet industry and other general economic factors; and new government
legislation and regulation.

 Comprehensive Income:

   The Company has adopted the accounting treatment prescribed by Financial
Accounting Statement No. 130, "Comprehensive Income." The adoption of this
statement had no impact on the Company's financial statements for the periods
presented, as net loss equals comprehensive loss.

 Segment Information:

   In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information." This
statement establishes standards for the way companies report information about
operating segments in financial statements. It also establishes standards for
related disclosures about products and services, geographic areas, and major
customers. In accordance with the provisions of SFAS No. 131, the Company has
determined that it does not currently have any separately reportable operating
segments. Revenues from foreign operations have been insignificant.

 Recently Issued Accounting Pronouncements:

   On March 4, 1998, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants ("AICPA") issued Statement
of Position No. 98-1 ("SOP 98-1"), "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." SOP 98-1 requires computer
software costs related to internal software that are incurred in the
preliminary project stage should be expensed as incurred. Once the
capitalization criteria of SOP 98-1 have been met, external direct costs of
materials and services consumed in developing or obtaining internal-use
computer software; payroll and payroll-related costs for employees who are
directly associated with and who devote time to the internal-use computer
software project (to the extent of the time spent directly on the project); and
interest costs incurred when developing computer software for internal use
should be capitalized. SOP 98-1 is effective for financial statements for
fiscal years beginning after December 15, 1998. Accordingly, the Company will
adopt SOP 98-1 in its consolidated financial statements for the year ending
September 30, 2000. The adoption of SOP 98-1 is not expected to have a material
effect on the consolidated financial statements of the Company.

                                      F-10
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   On April 3, 1998, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position No. 98-5 (SOP 98-5), "Reporting on the Costs of
Start-Up Activities," which provides guidance on the financial reporting of
start-up costs and organization costs. SOP 98-5 requires costs of start-up
activities and organization costs to be expensed as incurred. SOP 98-5 is
effective for financial statements for fiscal years beginning after December
15, 1998. As the Company has not capitalized such costs, the adoption of SOP
98-5 is not expected to have an impact on the consolidated financial statements
of the Company.

   In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and Hedging
Activities." SFAS 133 establishes accounting and reporting standards for
derivative instruments and for hedging activities. SFAS 133 is effective for
fiscal years beginning after June 15, 2000. The Company does not believe the
adoption of SFAS 133 will have a material effect on the Company's consolidated
results of operations or financial condition.

3. Property and Equipment:

   Property and equipment consists of the following (in thousands):

<TABLE>
<CAPTION>
                                                                 September 30,
                                                                 --------------
                                                                  1998   1999
                                                                 ------ -------
   <S>                                                           <C>    <C>
   Network equipment............................................ $2,299 $ 7,404
   Communications equipment.....................................    194     217
   Computer equipment and software..............................    515   3,316
   Furniture, fixtures, and leasehold improvements..............    491   6,339
   Equipment and fixtures under capital leases..................  2,407  12,189
                                                                 ------ -------
                                                                  5,906  29,465
   Less accumulated depreciation and amortization...............    968   4,192
                                                                 ------ -------
   Total property and equipment, net............................ $4,938 $25,273
                                                                 ====== =======
</TABLE>

4. Income Taxes:

   For the years ended September 30, 1997, 1998, and 1999, the provision for
income taxes consists of state taxes.

   The primary components of the net deferred tax asset are as follows (in
thousands):

<TABLE>
<CAPTION>
                                                               September 30,
                                                              -----------------
                                                               1998      1999
                                                              -------  --------
   <S>                                                        <C>      <C>
   Net operating loss carryforwards, federal and state....... $ 8,635  $ 26,999
   Accrued employee benefits.................................      61       274
   Sales tax.................................................       1         2
   Accounts receivable allowance.............................      22       152
   Deferred Revenue..........................................     --        267
   Property and equipment....................................    (358)   (1,628)
                                                              -------  --------
                                                                8,361    26,066
   Less valuation allowance..................................  (8,361)  (26,066)
                                                              -------  --------
                                                              $   --   $    --
                                                              =======  ========
</TABLE>

                                      F-11
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   Due to the uncertainty surrounding the realization of the favorable tax
attributes in future tax returns, the Company has placed a valuation allowance
against its otherwise recognizable net deferred tax assets. The valuation
allowance increased by $6.2 million and $17.7 million for the years ended
September 30, 1998 and 1999, respectively. The effective income tax rate
differs from the statutory federal income tax rate primarily due to the
inability to recognize the benefit of net operating losses.

   At September 30, 1999, the Company had NOL carryforwards of approximately
$72.0 million for both federal and state income tax purposes. These
carryforwards expire beginning 2009 and 2002, respectively.

   Pursuant to the provisions of Section 382 of the Internal Revenue Code,
utilization of the NOLs are subject to annual limitations through 2014 due to a
greater than 50% change in the ownership of the Company which occurred during
fiscal 1998.

5. Bank Borrowings:

   Bank borrowings consist of (in thousands):

<TABLE>
<CAPTION>
                                                                 September 30,
                                                                 --------------
                                                                  1998    1999
                                                                 ------  ------
   <S>                                                           <C>     <C>
   Line of credit............................................... $  230  $  230
   Revolving credit facility....................................    579     323
   Equipment term facility......................................    876     562
                                                                 ------  ------
                                                                  1,685   1,115
   Current maturities...........................................   (801)   (801)
                                                                 ------  ------
   Long-term bank borrowings.................................... $  884  $  314
                                                                 ======  ======
</TABLE>

   On November 21, 1996, the Company entered into a revolving credit agreement
(the "Revolving Agreement") with a commercial lender. The aggregate credit
under the Revolving Agreement was originally $250,000, and was increased to
$750,000 on April 18, 1997. Interest under the Revolving Agreement is 0.75%
over the "Prime Rate" as announced from time to time by the lender. At
September 30, 1998 and 1999, the effective interest rate was 9.25% and 9.00%,
respectively. The weighted average interest rates for the years ended September
30, 1998 and 1999, were 9.25%, and 8.61%, respectively. Under the terms of the
Revolving Agreement, advances could be made for the purchase of equipment until
October 18, 1997. At that date, the unpaid principal balance of equipment
advances plus interest became payable over 36 months in equal installments.
Outstanding borrowings under the Revolving Agreement at September 30, 1998 and
1999 were $579,000 and $323,000, respectively. All amounts outstanding related
to advances for equipment purchases.

   On November 19, 1997, the Company entered into a loan agreement (the Loan
Agreement) with the same commercial lender associated with the Revolving
Agreement. Under the terms of the Loan Agreement, the Company was extended a
$5,000,000 line of credit, as well as an equipment loan term facility for
$2,500,000. Any borrowings under this line of credit are collateralized by
substantially all assets of the Company. Certain of the Loan Agreement's
provisions restrict the ability of the Company to declare or pay any dividends
while the credit agreement is in effect.

   Advances under the line of credit are limited to a percentage of the
Company's recurring contract revenues, as defined in the Loan Agreement. The
Loan Agreement contains certain standard covenants. $230,0000 was outstanding
under the line of credit at both September 30, 1998 and 1999. Interest on
borrowings are charged at the lender's prime rate plus 0.25%, which was 8.75%
and 8.50% at September 30, 1998 and 1999, respectively. The weighted average
interest rates for the years ended September 30, 1998 and

                                      F-12
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

1999 were 8.75% and 8.13%, respectively. Advances under the line of credit can
be repaid and reborrowed at any time until the maturity date of May 31, 2000.

   Under the terms of the equipment loan term facility, the Company had the
ability to borrow up to $1,250,000 for equipment purchases from November 19,
1997 to May 19, 1998 (Equipment Line A), as well as borrow an additional
$1,250,000 from February 1, 1998 to September 30, 1998 (Equipment Line B). At
September 30, 1998 and 1999, $224,000 and $140,000, respectively, was
outstanding related to advances made under Equipment Line A, and $652,000 and
$422,000, respectively, was outstanding related to advances made under
Equipment Line B. Interest on these borrowings are charged at the lender's
prime rate plus 0.75%, which was 9.25% and 9.00% at September 30, 1998 and
1999, respectively. The weighted average interest rates for the years ended
September 30, 1998 and 1999 were 9.25% and 8.61%, respectively. Repayments of
advances on Equipment Line A commenced on June 19, 1998, with the unpaid
principal balance as of May 19, 1998, plus interest, being repaid in 36 equal
monthly installments. Repayments of advances on Equipment Line B commenced on
October 19, 1998 in 34 monthly installments of principal and interest.

   The Loan Agreement was due to mature on November 19, 1998. On November 18,
1998, the Loan Agreement was modified to extend the maturity date to February
15, 1999. On February 15, 1999 the Loan Agreement was modified again to extend
the maturity date to May 31, 1999. On May 31, 1999, the Loan Agreement was
modified yet again to extend the maturity date to May 31, 2000.

   The Company did not comply with certain financial covenants at various
points during fiscal 1998, and accordingly, received an amendment and waiver
dated October 6, 1998 from its lender, which waived covenant violations for
periods prior to September 30, 1998 and eliminated one financial covenant with
respect to a minimum profitability threshold. Subsequent to September 30, 1998,
the Company did not comply with certain financial covenants. The Company
obtained waivers for all covenant violations from October 1, 1998 to January
31, 1999. Since the date of this most recent waiver the Company has been in
compliance with all covenants.

   Interest expense for the years ended September 30, 1997, 1998 and 1999 was
$36,000, $94,000, and $123,000, respectively.

   Principal maturities of bank borrowings are as follows (in thousands):

<TABLE>
<CAPTION>
     Year ending September 30,
     -------------------------
     <S>                                                                 <C>
     2000............................................................... $  801
     2001...............................................................    314
                                                                         ------
                                                                         $1,115
                                                                         ======
</TABLE>

6. Notes Payable:

   Between September 27, 1996 and January 31, 1997, the Company issued three
convertible notes totalling $600,000 to a commercial lender. These notes had a
simple interest rate of 6%. In March 1997, all three notes plus accrued
interest of $8,454 were converted into 608,454 shares of Series A preferred
stock.

   Prior to October 1, 1996, the Company had issued a $50,000 convertible note
to a related party. In March 1997, this note was converted into 50,000 shares
of Series A preferred stock.

                                      F-13
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


7. Accrued Liabilities:

   Accrued liabilities consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                                    September 30,
                                                                    -------------
                                                                    1998   1999
                                                                    ------ ------
   <S>                                                              <C>  <C>
   Employee compensation........................................... $596 $2,254
   Other accrued liabilities.......................................  120  2,677
                                                                    ---- ------
     Total......................................................... $716 $4,931
                                                                    ==== ======
</TABLE>

8. Commitments:

 Leases:

   The Company leases office space under noncancelable operating leases
expiring through April, 2014. Rent expense for the years ended September 30,
1997, 1998, and 1999, was $137,000, $715,000, and $3.2 million, respectively.

   The Company's future minimum lease payments under noncancelable operating
leases having an initial or remaining term of more than one year, and capital
leases are as follows (in thousands):

<TABLE>
<CAPTION>
     Year ending September 30,                                 Operating Capital
     -------------------------                                 --------- -------
     <S>                                                       <C>       <C>
     2000.....................................................  $ 5,389  $4,531
     2001.....................................................    6,506   4,113
     2002.....................................................    6,477   2,297
     2003.....................................................    6,268      10
     2004.....................................................    5,337     --
     Thereafter...............................................   20,838     --
                                                                -------  ------
       Total minimum lease payments...........................  $50,815  10,951
                                                                =======
     Less amounts representing interest.......................             (974)
                                                                         ------
     Present value of minimum lease payments..................            9,977
     Less current portion of capital lease obligations........           (3,916)
                                                                         ------
     Long-term portion of capital lease obligations...........           $6,061
                                                                         ======
</TABLE>

 Carrier Line Agreements:

   The Company has entered into various bandwidth capacity agreements with
domestic and foreign carriers. These agreements are generally cancelable and
provide for termination fees if cancelled by the Company prior to expiration.

                                      F-14
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


9. Earnings Per Share:

   The following is a reconciliation of the numerator and denominator of basic
and diluted earnings per share ("EPS"):

<TABLE>
<CAPTION>
                                                 Years Ended September 30,
                                              ---------------------------------
                                                1997        1998        1999
                                              ---------  ----------  ----------
<S>                                           <C>        <C>         <C>
Numerator--Basic and Diluted EPS
  Net Loss (in thousands)...................  $  (5,289) $  (16,764) $  (50,938)
                                              =========  ==========  ==========
Denominator--Basic and Diluted EPS
  Weighted average Common Stock
   outstanding..............................  1,497,711   2,361,010  11,280,534
  Common Stock subject to repurchase........        --     (124,558)   (153,072)
                                              ---------  ----------  ----------
  Total weighted average Common Stock
   outstanding..............................  1,497,711   2,236,452  11,127,462
                                              =========  ==========  ==========
Basic and diluted loss per share............  $   (3.53) $    (7.50) $    (4.58)
                                              =========  ==========  ==========
Pro forma:
  Denominator--Basic and Diluted EPS
  Weighted Average Common Stock.............              2,361,010   4,752,354
  Conversion of Preferred Stock.............              9,711,087  20,538,798
  Conversion of Warrants....................                 95,000      95,000
  Common Stock subject to repurchase........               (124,558)   (153,072)
                                                         ----------  ----------
  Total weighted average Common Stock
   outstanding pro Forma....................             12,042,539  25,233,080
                                                         ==========  ==========
Basic and diluted pro forma loss per share..             $    (1.39) $    (2.02)
                                                         ==========  ==========
</TABLE>

10. Stockholders' Equity:

   In June 1999, the Company completed its initial public offering ("IPO") of
6,000,000 shares of its common stock. Subsequent to the IPO, the underwriters
purchased an additional 900,000 shares to cover over-allotments. The net
proceeds to the Company after deducting underwriting discounts and commissions
and offering expenses, was approximately $63.1 million. In conjunction with the
IPO, all shares of Series A, B, C, D, and E convertible preferred stock were
converted to common stock. Immediately prior to this conversion, an additional
178,138 shares of Series D preferred stock were issued in accordance with
certain anti-dilution provisions. All of these additional shares were converted
into common stock. In addition, all outstanding warrants were exercised prior
to the IPO for 95,000 shares of common stock.

   In June 1999, the Company was reincorporated in the state of Delaware.
Pursuant to the reincorporation, each share of common and preferred stock of
the Company's California predecessor entity was exchanged for one share of
common and preferred stock of the newly formed Delaware entity. Pursuant to the
reincorporation, the number of authorized shares of common stock increased to
100,000,000 with a par value of $0.001 per share. Additionally, 10,000,000
shares of undesignated preferred stock were authorized with a par value of
$0.001 per share.

                                      F-15
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   Convertible preferred stock issued and outstanding prior to the IPO was as
follows:

<TABLE>
<CAPTION>
                                                                   Liquidation
                                             Shares   Issued and      Value
     Series                                Designated Outstanding (in thousands)
     ------                                ---------- ----------- -------------
     <S>                                   <C>        <C>         <C>
     A....................................  4,000,000  4,000,000    $  4,000
     B....................................  3,000,000  3,000,000    $  7,500
     C....................................  4,300,000  4,283,181    $ 14,777
     D....................................  2,700,000  2,200,614    $ 10,618
     E.................................... 11,764,706 11,764,706    $ 50,000
                                           ---------- ----------    --------
                                           25,764,706 25,248,501    $ 86,895
                                           ========== ==========    ========
</TABLE>

11. Stock Plans:

 Stock Option Plans:

   In January 1997, the Company established the 1997 Stock Option and Incentive
Plan (the "1997 Plan") and reserved up to 1,689,125 shares of common stock
issuable upon exercise of options granted to certain employees, directors, and
consultants. In May 1998, the Company adopted the 1998 Stock Option/Stock
Issuance Plan (the "1998 Plan"). The 1998 Plan was designed to serve as the
successor to the 1997 Plan. Upon adoption of the 1998 Plan the existing share
reserve under the 1997 Plan was transferred to the 1998 Plan, and all
outstanding options under the 1997 Plan were incorporated into the 1998 Plan.
The Company increased the maximum number of shares issuable to a total of
3,833,284. In November 1998, the Company increased the stock option pool by
another 600,000 shares, bringing the total to 4,433,284. This number of shares
was reserved for issuance under the 1998 Plan. In June 1998, concurrent with
the IPO, the Company adopted the 1999 Stock Incentive Plan (the "1999 Plan").
The 1999 Plan was designed to serve as the successor to the 1998 Plan. Upon the
initial public offering of the Company's common stock, all outstanding options
under the 1998 Plan, together with the remaining shares reserved under that
plan, were incorporated into the 1999 Plan, with no further grants of common
stock options to be made under the 1998 Plan. Upon implementation of the 1999
Plan, an additional 2,110,716 shares of common stock were reserved for
issuance. A total of 7,544,000 shares are now reserved for issuance.

   Under the terms of the 1999 Plan, the Company has the ability to grant
incentive and nonstatutory stock options, as well as issue vested and unvested
shares of the Company's common stock. Exercise prices of stock options are
generally not less than 100% and 85% of the fair value of the common stock on
the date of grant of incentive stock options and nonstatutory stock options,
respectively, and have a term of up to ten years. Options generally vest
rateably over a period of up to fifty months after the grant date, subject to
accelerated vesting in connection with certain changes in control or ownership
of the Company. The plan provides that management can grant employees the right
to exercise options prior to vesting. Upon termination of an employee's
employment with the Company for any reason, the Company has the right to
repurchase all or any portion of the unvested shares acquired by the employee
upon exercise of options at a repurchase price that is equal to the exercise
price, within 90 days following the date of termination. At September 30, 1999,
1998, and 1997, 205,700, 254,125, and 0 shares of common stock were subject to
repurchase by the Company.

                                      F-16
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   A summary of the activity under the 1997 Plan, the 1998 Plan, and the 1999
Plan is as follows (dollars in thousands):

<TABLE>
<CAPTION>
                                                                     Weighted
                                             Exercise    Aggregate   Average
                                            Price Per    Exercise    Exercise
                                 Shares       Share        Price      Price
                               ----------  ------------ -----------  --------
   <S>                         <C>         <C>          <C>          <C>
   Outstanding at September
    30, 1996..................        --            --          --      --
     Granted..................  1,688,500  $       0.40 $   675,400   $0.40
     Terminated...............   (105,000) $       0.40     (42,000)   0.40
                               ----------  ------------ -----------   -----
   Outstanding at September
    30, 1997..................  1,583,500  $       0.40     633,400    0.40
     Granted..................  1,903,009  $0.40-$ 3.35   3,283,649    1.73
     Exercised................   (297,960) $0.40-$ 1.50    (265,784)   0.89
     Terminated...............   (194,784) $0.40-$ 3.25     (91,564)   0.47
                               ----------  ------------ -----------   -----
   Outstanding at September
    30, 1998..................  2,993,765  $0.40-$ 3.35   3,559,701    1.19
     Granted..................  2,412,350  $3.35-$26.00  19,109,274    7.92
     Exercised................ (1,178,391) $0.40-$ 9.90  (1,142,950)   0.97
     Terminated...............   (380,155) $0.40-$10.00  (1,167,204)   3.07
                               ----------  ------------ -----------   -----
   Outstanding at September
    30, 1999..................  3,847,569  $0.40-$26.00 $20,358,821   $5.29
                               ==========  ============ ===========   =====
</TABLE>

   The Company accounts for the 1997 Plan, the 1998 Plan, and the 1999 Plan
using the intrinsic value based method in accordance with Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees,"
and related interpretations. For financial reporting purposes, the Company has
determined that the deemed fair value on the date of grant of employee stock
options granted between May 1, 1998 and April 21, 1999 was in excess of the
exercise price of the options. Consequently, the Company recorded deferred
compensation of $2.0 million for the year ended September 30, 1998, and an
additional $5.7 million for the year ended September 30, 1999. Of the total
deferred compensation, $487,000 was amortized during the year ended September
30, 1998 and $3.2 million was amortized during the year ended September 30,
1999.

   At September 30, 1999 options to purchase 1,541,814 shares of common stock
were exercisable with a weighted average exercise price of $1.60 per share.

   At September 30, 1998 and 1999, options to purchase 541,559 and 2,220,080
shares of common stock, respectively, remain available for issuance.

   The following summarizes information with respect to stock options
outstanding at September 30, 1999:

<TABLE>
<CAPTION>
                              Options Outstanding          Options Exercisable
                     ------------------------------------- --------------------
                                 Weighted Average Weighted             Weighted
                                    Remaining     Average              Average
      Range of         Number      Contractual    Exercise   Number    Exercise
  Exercise Prices    Outstanding   Life (Years)    Prices  Exercisable  Prices
  ---------------    ----------- ---------------- -------- ----------- --------
<S>                  <C>         <C>              <C>      <C>         <C>
$0.40-$0.60.........    561,607        7.49        $ 0.41    166,921    $ 0.40
$0.90-$1.50.........    877,923        8.92        $ 1.43    454,862    $ 1.49
$2.75-$3.35.........    123,905        8.88        $ 3.10    123,905    $ 3.10
$3.50-$4.25.........  1,396,084        9.52        $ 4.02    397,052    $ 3.96
$7.50-$10.00........    489,300        9.69        $ 9.46    398,683    $ 9.41
$18.875-$20.50......    331,750        9.82        $20.10        391    $20.21
$23.750-$26.00......     67,000        9.96        $24.46        --        --
</TABLE>

   The following information concerning the Company's 1999 Plan is provided in
accordance with Statement of Financial Accounting Standards No. 123 ("SFAS
123"), "Accounting for Stock-Based Compensation."

                                     F-17
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The fair value of each option grant has been estimated on the date of grant
using the minimum value method with the following weighted average assumptions
used for grants in the years ended September 30, 1998 and 1999:

<TABLE>
<CAPTION>
                                      September 30, September 30, September 30,
                                          1997          1998          1999
                                      ------------- ------------- -------------
     <S>                              <C>           <C>           <C>
     Risk-free interest rates........  5.85%-6.86%   4.23%-6.08%      5.80%
     Expected life...................    5 years       5 years       4 years
     Expected dividend yield.........      --            --            --
     Expected volatility.............      --            --            80%
</TABLE>

   The weighted average fair value for options granted was $0.10, $0.36 and
$1.71 for the years ended September 30, 1997, 1998, and 1999, respectively.

   The pro forma net loss for the Company for the years ended September 30,
1997, 1998 and 1999 following the provisions of SFAS 123, was $5.3 million,
$16.8 million and $51.6 million respectively. The pro forma basic and diluted
net loss per share for the years ended September 30, 1997, 1998 and 1999 was
$3.55, $7.53 and $4.63, respectively.

 Employee Stock Purchase Plan:

   In June 1999, the Company adopted the 1999 Employee Stock Purchase Plan
("1999 ESPP"). Under the 1999 ESPP, eligible employees are allowed to have
salary withholdings of up to a certain specified percentage of their base
compensation to purchase shares of common stock at a price equal to 85% of the
lower of the market value of the stock at the beginning or end of defined
purchase periods. The initial purchase period commenced on July 1, 1999. A
total of 300,000 shares is reserved for issuance under the 1999 ESPP. At
September 30, 1999 a total of $581,000 had been withheld from employees for
future purchases under this plan.

12. Stockholder Notes Receivable:

   On February 25, 1998, the Company granted a nonstatutory option to purchase
a total of 183,000 shares of the Company's common stock to a director of the
Company (the "Director"). These options were immediately exercisable and the
shares purchased thereunder are subject to repurchase by the Company, with the
right to repurchase expiring in 16 equal quarterly installments. At the time of
the option grant, the Director exercised the option to purchase the entire
183,000 shares of common stock, in exchange for a $109,800 note (the "Note").
The Note was collateralized by the 183,000 shares of common stock and by other
assets of the Director. Under the terms of the note, interest was accrued at
5.61% per annum. Interest was to be repaid in four equal annual installments
commencing February 24, 1999. The entire principal amount was due and payable
in one lump sum on February 24, 2002. In August 1999, the Director extinguished
the Note by paying the full amount of principal and accrued interest. At
September 30, 1999, a total of 114,375 shares of the Director's stock was
subject to repurchase.

   On April 20, 1999, executive officers of the Company exercised stock options
to purchase 349,332 shares of common stock in exchange for full-recourse notes.
The total principal amount of these notes is $286,398. The notes bear interest
at the rate of 7.75% per annum, compounded semiannually. Accrued interest is
due and payable at successive quarterly intervals over the four-year term of
the note, and the principal balance will become due and payable in one lump sum
at the end of the four year term. None of the shares purchased with the notes
may be sold unless the principal portion of the note attributable to those
shares, together with the accrued interest on that principal portion, is paid
in full.

                                      F-18
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   On June 14, 1999, one of the executive officers who had exercised options on
April 20, 1999 in exchange for a full-recourse note, borrowed an additional
$128,000 in order to finance the tax liability she incurred in connection with
the exercise of her stock options on April 20, 1999 for 133,332 shares of
common stock. The loan is evidenced by a full-recourse promissory note with
interest at the rate of 7.75% per annum, compounded semi-annually, and secured
by the same 133,332 shares which serve as collateral for the April 20, 1999
promissory note, as well as other assets. The terms of her note, including the
due dates for payment of principal and accrued interest and the acceleration
provisions, are substantially the same as the terms in effect for her April 20,
1999 note.

   In July 1999, the Company loaned an officer of the Company $100,000. The
loan is interest free, with $50,000 being forgiven ratably over a period of
five years. At the end of the five year term, the $50,000 portion of the loan
that has not been forgiven is to be repaid in one lump sum. In the event that
the officer's employment terminates during the five year period, the
outstanding unforgiven balance of the loan is to be repaid at the time of the
termination. The amount being forgiven, plus imputed interest are charged to
operations.

13. Warrants:

   In connection with the issuance of certain convertible notes (see Note 6),
the Company issued warrants to purchase shares of the Company's common stock to
the note holders. Warrants to purchase 75,000 and 20,000 shares of the
Company's common stock were granted in September 1996 and January 1997,
respectively. The exercise price of the warrants was equal to $0.10 per share.
The warrants were due to expire upon the earlier of (i) five years from the
date of grant, (ii) the closing of a underwritten public offering of the
Company's common stock for not less than $2.50 per share and gross proceeds of
at least $10,000,000, or (iii) the closing of a consolidation or merger of the
Company. The fair value of the warrants was determined using the Black-Scholes
model and was accounted for as interest expense over the time period the notes
were outstanding. In June 1999, prior to the IPO, the warrants were exercised.

14. Related Party Transactions:

   One shareholder also is a significant customer of the Company. For the years
ended September 30, 1997, 1998, and 1999, the Company earned $122,000,
$310,000, and $524,000, respectively, in revenue from sales to this customer,
and had $139,000, and $200,000 in total receivables at September 30, 1998 and
1999, respectively. The Company owed this customer $992,000 and $3.8 million at
September 30, 1998 and 1999, respectively, under terms of the master lease
agreement, and also owed another $94,000 and $68,000, respectively, in other
trade-related payables.

   One other significant shareholder is also a customer of the Company. For the
years ended September 30, 1997, 1998, and 1999, the Company earned $43,000,
$458,000, and $4.4 million, respectively, in revenue from sales to this
customer, and had $39,000 and $1.4 million in total receivables at September
30, 1998 and 1999, respectively. In addition, $715,000 of the deferred revenue
balance at September 30, 1999 related to this customer.

15. Retirement Savings Plan:

   On November 1, 1997, the Company established the Digital Island Retirement
Savings Plan ("Retirement Plan"), a defined contribution plan, covering all
eligible employees. Employees may elect to contribute from 1%-15% of their
annual compensation to the Retirement Plan. Matching contributions by the
Company are discretionary. The Company has made no contributions during the
years ended September 30, 1998 and 1999.

                                      F-19
<PAGE>

                     DIGITAL ISLAND, INC. AND SUBSIDIARIES

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


16. Subsequent Events:

   In October 1999, options to purchase 32,250 and 446,500 shares of common
stock were granted at exercise prices of $23.3125 and $38.6875 per share,
respectively.

   On October 25, 1999, the Company agreed to merge with Sandpiper Networks,
Inc. ("Sandpiper") in a transaction to be accounted for as a purchase. The
merger is subject to approval by stockholders. The terms of the merger call for
1.07 shares of Digital Island, Inc. common stock to be exchanged for each share
of Sandpiper stock. Sandpiper stock options will be assumed by Digital Island,
Inc. at the same ratio. An estimated 24.5 million shares of Digital Island
common stock are to be exchanged.

   In December 1999, Sun Microsystems, Inc. (Sun) agreed to make an equity
investment in the Company of $20,000,000. Sun also agreed to extend to the
Company a $100,000,000 credit facility for the acquisition of Sun equipment,
under the terms of the Master Lease Line of Credit and Warrant Agreement (the
Sun Agreement). The terms of the Sun Agreement calls for the credit to be made
available upon the achievement of certain milestones. The achievement of these
milestones also triggers granting of warrants to Sun to purchase up to a
maximum of $10,000,000 worth of the Company's common stock. Sun and the Company
have also agreed to a joint marketing campaign to be partially funded by Sun.

   In December 1999, Inktomi Corporation (Inktomi) agreed to make an equity
investment in the Company of $6,000,000 under the terms of a Strategic Alliance
agreement. The terms of this agreement also calls for a joint marketing
campaign to be partially funded by Inktomi. The Company has previously licensed
certain products from Inktomi in the ordinary course of business, under the
terms of the Inktomi License Agreement (License Agreement) which was executed
in January 1999. The Company has agreed to license additional products under
the terms of an amendment to the License Agreement that was executed in
December 1999.

   In December 1999, the Company agreed to purchase patented technology from
SRI International (SRI). Under terms of the agreement, the Company is to
acquire the technology in exchange for $10,000,000 of common stock, to be
distributed upon the occurrence of certain milestones.

                                      F-20
<PAGE>

       REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE

Board of Directors and Stockholders of Digital Island, Inc.

   We have audited the financial statements of Digital Island, Inc. as of
September 30, 1999 and 1998, and for each of the three years in the period
ended September 30, 1999, and have issued our report thereon dated October 29,
1999. Our audits also included the financial statement schedule listed in Item
14(a) of this Annual Report. This schedule is the responsibility of the
Company's management. Our responsibility is to express an opinion based on our
audits.

   In our opinion, the financial statement schedule referred to above, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information required to be
included therein.

/s/ PricewaterhouseCoopers LLP

San Francisco, California
October 29, 1999

                                      S-1
<PAGE>

                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS

                              Digital Island, Inc.

<TABLE>
<CAPTION>
                                  Balance at Charged to             Balance at
                                  Beginning   Cost and                End of
           Description            of Period   Expenses   Deductions   Period
           -----------            ---------- ----------- ---------- -----------
<S>                               <C>        <C>         <C>        <C>
Year ended September 30, 1997:
    Deferred tax valuation
     allowance................... $   22,000 $ 2,121,000  $    --   $ 2,143,000
                                  ---------- -----------  --------  -----------
     Total....................... $   22,000 $ 2,121,000  $    --   $ 2,143,000
                                  ========== ===========  ========  ===========
Year ended September 30, 1998:
    Allowance for doubtful
     accounts.................... $      --  $   111,104  $ 56,104  $    55,000
    Deferred tax valuation
     allowance................... $2,143,000 $ 6,218,000  $    --   $ 8,361,000
                                  ---------- -----------  --------  -----------
     Total....................... $2,143,000 $ 6,329,104  $ 56,104  $ 8,416,000
                                  ========== ===========  ========  ===========
Year ended September 30, 1999:
    Allowance for doubtful
     accounts.................... $   55,000 $   471,602  $146,192  $   380,410
    Deferred tax valuation
     allowance................... $8,361,000 $17,705,000  $    --   $26,066,000
                                  ---------- -----------  --------  -----------
     Total....................... $8,416,000 $18,176,602  $146,192  $26,446,410
                                  ========== ===========  ========  ===========
</TABLE>

                                      S-2
<PAGE>

                                 EXHIBIT INDEX


<TABLE>
<CAPTION>
 Exhibit
 Number                              Exhibit Title
 -------                             -------------
 <C>     <S>
  2.1    Agreement and Plan of Reorganization dated as of October 24, 1999, by
         and among the Registrant, Beach Acquisition Corp. and Sandpiper
         Networks, Inc. (attached as Annex A to the joint proxy/prospectus
         contained in the Registration Statement on Form S-4 as filed as
         Exhibit 99.1 herewith)
  3.1*   Registrant's Amended and Restated Certificate of Incorporation
  3.2*   Registrant's Amended and Restated Bylaws
  4.1*   Specimen Stock Certificate
  4.2*   Amended and Restated Investors' Rights Agreement among the Registrant
         and the parties listed on the signature pages thereto dated as of
         February 19, 1999
  4.3*   Registrant's Amended and Restated Certificate of Incorporation (See
         Exhibit 3.1)
  4.4*   Registrant's Amended and Restated Bylaws (See Exhibit 3.2)
  4.5*   Amendment No. 1 to the Amended and Restated Investors' Rights
         Agreement, dated April 9, 1999
 10.1*   1997 Stock Option Agreement
 10.2*   1998 Stock Option/Stock Issuance Agreement
 10.3*   1999 Stock Incentive Plan
 10.4*   1999 Employee Stock Purchase Plan
 10.5*   Form of Indemnification Agreement for Officers and Directors
 10.6*   Employment Agreement between the Registrant and Ruann F. Ernst
 10.7*   Employment Agreement between the Registrant and Allan Leinwand
 10.8*   Employment Agreement between the Registrant and Timothy M. Wilson
 10.9*   Employment Agreement between the Registrant and Paul Evenson
 10.10*  Employment Agreement between the Registrant and Leo S. Spiegel
 10.11*  Employment Agreement between the Registrant and Andrew Swart
 10.12*  Employment Agreement between the Registrant and David Farber
 10.13*  Lease between the Registrant and Bishop Street Associates, dated
         October 21, 1996, as amended to date
 10.14*  Lease agreement between the Registrant and Forty-Five Fremont
         Associates, dated May 5, 1999
 10.15*  Note Secured by Stock Pledge Agreement by Ruann F. Ernst to
         Registrant, dated April 21, 1999
 21.1*   Subsidiaries of Registrant
 23.1    Consent of Independent Auditors
 24.1    Power of Attorney (see signature page to this Form 10-K)
 27.1    Financial Data Schedule
 99.1    Registration Statement on Form S-4, filed with the Commission on
         December 9, 1999
</TABLE>
--------
*  Incorporated by reference to the corresponding Exhibit of the Registrant's
   Registration Statement on Form S-4 (File No. 333-92393), filed on December
   9, 1999.