##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




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Form 10-K



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|           |  |                                                                                                 
|---------- |  | ------------------------------------------------------------------------------------------------
|(Mark One)
|          
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|           |  | For the fiscal year ended July 31,
    2004                                                     
|          
|or        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|          
|           |  | For the transition period
    from          to                                                  

Commission file number: 000-27597



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NaviSite, Inc.

(Exact name of registrant as specified in its
charter)


|                                                                                          |  |                                         
|----------------------------------------------------------------------------------------- |  | ----------------------------------------
|Delaware                                                                                  |  | 52-2137343                              
|(State or other jurisdiction of
    incorporation)                                        |  | (I.R.S. Employer
    Identification No.)
|                                                                                         
|400 Minuteman Road
    Andover, Massachusetts(Address of principal executive
    offices) |  | 01810(Zip Code)                         

(Registrants telephone number, including
area code)

(978) 682-8300




---

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

None


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

Common Stock, $0.01 par value


(Title of Class)


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

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

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Act).     Yes o          No þ

The aggregate market value of the
registrants common stock, $0.01 par value per share,
held by non-affiliates of the registrant was approximately
$14,193,990 based on the last reported sale price of the
registrants common stock on the Nasdaq SmallCap Market as
of the close of business on January 30, 2004.

As of September 30, 2004, there were
27,928,724 shares outstanding of the registrants
common stock, par value $0.01 per share.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrants definitive
proxy statement for its annual meeting of stockholders for the
fiscal year ended July 31, 2004, which will be filed with
the Securities and Exchange Commission within 120 days
after the end of the registrants fiscal year, are
incorporated by reference into Part III hereof.



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NAVISITE, INC.

2004 ANNUAL REPORT

ON FORM 10-K


TABLE OF CONTENTS

|                                                 |  |                                                                                                                      |  |        |    | 
|------------------------------------------------ |  | -------------------------------------------------------------------------------------------------------------------- |  | ------ | -- | 
|                                                 |  |                                                                                                                      |  | Page  
|                                                 |  |                                                                                                                      |  | Number
|                                                 |  |                                                                                                                      |  |       
|PART I                                          
|Item 1.                                          |  | Business                                                                                                             |  |        | 3  | 
|Item 2.                                          |  | Properties                                                                                                           |  |        | 22 | 
|Item 3.                                          |  | Legal Proceedings                                                                                                    |  |        | 23 | 
|Item 4.                                          |  | Submission of Matters to a
    Vote of Security Holders                                                              |  |        | 27 | 
|PART II                                         
|Item 5.                                          |  | Market for Registrants
    Common Equity, Related Stockholder Matters and Issuer Purchases
    of Equity Securities |  |        | 27 | 
|Item 6.                                          |  | Selected Consolidated
    Financial Data                                                                             |  |        | 29 | 
|Item 7.                                          |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations                            |  |        | 30 | 
|Item 7A.                                         |  | Quantitative and Qualitative
    Disclosures about Market Risk                                                       |  |        | 41 | 
|Item 8.                                          |  | Financial Statements and
    Supplementary Data                                                                      |  |        | 41 | 
|Item 9.                                          |  | Changes in and Disagreements
    With Accountants on Accounting and Financial Disclosure                             |  |        | 42 | 
|Item 9A.                                         |  | Controls and Procedures                                                                                              |  |        | 42 | 
|Item 9B.                                         |  | Other Information                                                                                                    |  |        | 42 | 
|PART III                                        
|Item 10.                                         |  | Directors and Executive
    Officers of the Registrant                                                               |  |        | 42 | 
|Item 11.                                         |  | Executive Compensation                                                                                               |  |        | 42 | 
|Item 12.                                         |  | Security Ownership of
    Certain Beneficial Owners and Management                                                   |  |        | 42 | 
|Item 13.                                         |  | Certain Relationships and
    Related Transactions                                                                   |  |        | 43 | 
|Item 14.                                         |  | Principal Accounting Fees
    and Services                                                                           |  |        | 43 | 
|PART IV                                         
|Item 15.                                         |  | Exhibits, Financial
    Statement Schedules                                                                          |  |        | 43 | 
|                                                 |  | Index to Consolidated
    Financial Statements                                                                       |  |        | 43 | 
|                                                 |  | Signatures                                                                                                           |  |        | 44 | 
|EX-10.56 Joinder Agreement dated July 28, 2004  
|EX-10.57 Loan Arrangement dated October 27, 2004
|EX-10.58 Loan Arrangement dated April 29, 2004  
|EX-21 Subsidiaries of Navisite, Inc.            
|EX-23 Consent of KPMG LLP                       
|EX-31.1 Section 302 CEO Certification           
|EX-31.2 Section 302 CFO Certification           
|EX-32.1 Section 906 CEO Certification           
|EX-32.2 Section 906 CFO Certification           



2



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##### Table of Contents






PART I

SPECIAL NOTE

All share numbers and share prices provided in
this Annual Report on Form 10-K have been adjusted to
reflect the 1-for-15 reverse stock split of our common stock
effected on January 7, 2003.

SPECIAL NOTE REGARDING FORWARD-LOOKING
STATEMENTS

This Form 10-K contains forward-looking
statements within the meaning of Section 21E of the
Securities Exchange Act of 1934, as amended, and
Section 27A of the Securities Act of 1933, as amended, that
involve risks and uncertainties. All statements other than
statements of historical information provided herein are
forward-looking statements and may contain information about
financial results, economic conditions, trends and known
uncertainties. Our actual results could differ materially from
those discussed in the forward-looking statements as a result of
a number of factors, which include those discussed in this
section and elsewhere in this report and the risks discussed in
our other filings with the Securities and Exchange Commission.
Readers are cautioned not to place undue reliance on these
forward-looking statements, which reflect managements
analysis, judgment, belief or expectation only as of the date
hereof. Investors are warned that actual results may differ
materially from managements expectations. We undertake no
obligation to publicly reissue or update these forward-looking
statements to reflect events or circumstances that arise after
the date hereof.






|        |         
|------- | --------
|Item 1. | Business

Our Business

We provide managed application services and a
broad range of outsourced hosting services for middle-market
organizations, which include mid-sized companies, divisions of
large multi-national companies and government agencies. Our
service offerings allow our customers to outsource the hosting
and management of their information technology infrastructure
and applications, such as commerce systems, enterprise software
applications and e-mail. We offer services that are designed to
focus on the needs of middle-market organizations, where we
believe the need for outsourcing is most acute. We believe that
by using our services, our customers are able to focus on, and
apply resources to, their core business operations by avoiding
the significant ongoing investments required to replicate our
infrastructure, performance, reliability and expertise. Our
services include:

|                                    |  |                                             
|----------------------------------- |  | --------------------------------------------
|Managed Application
    Services    |  | Application Hosting                         
|(A-Services)                        |  | Application Management                      
|                                    |  | Application Development                     
|Managed
    Infrastructure Services |  | Content and Electronic Software Distribution
|(I-Services)                        |  | Colocation                                  
|                                    |  | Bandwidth                                   
|                                    |  | Security                                    
|                                    |  | Disaster Recovery                           
|Managed Messaging
    Services      |  | Managed Messaging                           
|(M-Services)                        |  |                                             

We support a broad portfolio of outsourced
application services including financial management, supply
chain management, human resources management and customer
relationship management. We provide these services to a range of
vertical industries through our direct sales force and channel
relationships. The applications we provide include PeopleSoft,
Siebel Systems, Progress Software and Microsoft Business
Solutions suite.

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Our service offerings are facilitated by our
proprietary Collaborative Application Management platform, or
CAM. Our CAM platform enables us, with our customers, to provide
highly efficient, effective and customized management of their
outsourced enterprise applications and information technology.
Comprised of a suite of third-party and proprietary products,
CAM provides tools designed specifically to meet the needs of
customers who outsource or want to provide on-demand application
services.

We believe that the combination of CAM with our
physical infrastructure and technical staff gives us a unique
ability to provision on-demand application services for software
providers for use by their customers. Because this on-demand
provisioning capability is not dependent on the individual
software application, CAM is application and operating platform
neutral. Designed to enable enterprise software applications to
be provisioned and used as an on-demand solution, the CAM
technology allows us to offer new solutions to our software
vendors and new products to our current customers.

We currently operate 14 data centers in the
United States and one data center in the United Kingdom. We
believe that our data centers and infrastructure have the
capacity necessary to expand our business for the foreseeable
future. Our services combine our developed infrastructure with
established processes and procedures for delivering hosting and
application management services. Our high availability
infrastructure, high performance monitoring systems, and
proactive and collaborative problem resolution and change
management processes are designed to identify and address
potentially crippling problems before they are able to disrupt
our customers operations.

We currently service approximately 1,150
customers, including approximately 148 customers through our
sales channel relationships. Our customers typically enter into
service agreements for a term of one to three years, which
provide for monthly payment installments, providing us with a
base of recurring revenue.

The audit report on our fiscal year 2004
consolidated financial statements from KPMG LLP, our independent
auditors, contains an explanatory paragraph that states that our
recurring losses since inception and accumulated deficit, as
well as other factors, raise substantial doubt about our ability
to continue as a going concern.

We were formed in 1996 within CMGI, Inc., our
former majority stockholder, to support the networks and host
Web sites of CMGI, its subsidiaries and several of its
affiliated companies. In 1997, we began offering and supplying
Web site hosting and management services to companies not
affiliated with CMGI. We were incorporated in Delaware in
December 1998. In October 1999, we completed our initial public
offering of common stock and remained a majority-owned
subsidiary of CMGI until September 2002. In September 2002,
ClearBlue Technologies, Inc., or CBT, and its subsidiaries
became our majority stockholder upon CBTs acquisition from
CMGI and Hewlett-Packard Financial Services Company of all of
their shares of our common stock then held, warrants to purchase
our common stock and convertible promissory notes issued by us
in exchange for shares of CBT common stock. In December 2002 and
August 2003, CBT transferred shares of our common stock held by
it to its stockholders, including the shares of our common stock
currently held by Hewlett-Packard Financial Services Company. In
connection with CBTs August 2003 transfers to its
stockholders of its remaining shares of our common stock,
Atlantic Investors, LLC, the indirect majority stockholder of
CBT, became our majority stockholder. As of September 30,
2004, Atlantic Investors owned approximately 61% of the issued
and outstanding shares of our common stock.

Our corporate headquarters are located at 400
Minuteman Road, Andover, Massachusetts, and our telephone number
is (978) 682-8300. Our Web site is found at
www.navisite.com. The information available on, or that can be
accessed through, our Web site is not a part of this report.

Fiscal Year 2004 Events and
Developments

Some of the significant events and developments
that impacted us during fiscal year 2004 included:



| |   |                                                                                                                                                                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | In August 2003, we acquired assets of CBT related
    to colocation, bandwidth, security and disaster recovery
    services, enhancing our Managed Infrastructure Services and
    adding physical plant assets. The acquisition was accounted for
    as a combination of entities under common control (i.e.,
    as if pooling).

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | Specifically, we acquired all of the outstanding
    shares of six wholly-owned subsidiaries of CBT with data centers
    located in Chicago, Illinois; Las Vegas, Nevada; Los Angeles,
    California; Milwaukee, Wisconsin; Oak Brook, Illinois; and
    Vienna, Virginia and assumed the revenue and expense of four
    additional wholly-owned subsidiaries of CBT with data centers
    located in Dallas, Texas; New York, New York;
    San Francisco, California; and Santa Clara,
    California. Pursuant to the acquisition agreement, as amended on
    February 6, 2004, we had the right to acquire from CBT
    ownership of those additional subsidiaries for no additional
    consideration at any time on or prior to August 8, 2005,
    provided that any necessary third-party consents are first
    obtained. In April 2004, we exercised our right to acquire the
    additional subsidiaries and thereby acquired all of the
    outstanding shares of the four wholly-owned subsidiaries of CBT
    with data centers located in Dallas, Texas; New York, New York;
    San Francisco, California; and Santa Clara, California.
|
| |  | In October 2003, our Board of Directors elected
    Thomas Evans to serve as a member of our Board of Directors.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  | On May 6, 2004, John J. Gavin, Jr.
    became our Chief Financial Officer, succeeding James W. Pluntze,
    who assumed the role of Senior Vice President of Finance.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|
| |  | On June 10, 2004, pursuant to an asset
    purchase agreement dated May 6, 2004, we completed the
    acquisition of substantially all of the assets and liabilities
    of Surebridge for three million shares of our common stock, two
    convertible promissory notes in the aggregate principal amount
    of approximately $39.3 million and the assumption of
    certain liabilities. This acquisition broadens our Managed
    Application Services, particularly in the areas of financial
    management, supply chain management, human resources management
    and customer relationship management.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

Our Industry

The dramatic growth in Internet usage and the
enhanced functionality, accessibility and security of
Internet-enabled applications have made conducting business on
the Internet increasingly attractive. Many businesses are using
Internet-enabled information technology infrastructure and
applications to enhance their core business operations, increase
efficiencies and remain competitive. Internet-enabled
information technology infrastructure and applications extend
beyond Web sites to software such as financial, email,
enterprise resource planning, supply chain management and
customer relationship management applications. Organizations
have become increasingly dependent on these applications and
they have evolved into important components of their businesses.

As enterprises seek to remain competitive and
improve profitability, we believe they will continue to
implement increasingly sophisticated Internet-enabled
applications. Some of the potential benefits of these
applications include the ability to:



| |   |                                                                                                                                                   
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------
| |  | increase operating efficiencies and reduce costs;                                                                                                 
|
| |  | build and enhance customer relationships by
    providing Internet-enabled customer service and technical
    support;                            
|
| |  | manage vendor and supplier relationships through
    Internet-enabled technologies such as online training and online
    sales and marketing; and
|
| |  | communicate and conduct business more rapidly and
    cost-effectively with customers, suppliers and employees
    worldwide.                     

These benefits have driven increased use of
Internet-enabled information technology infrastructure and
applications which in turn have created a strong demand for
specialized information technology support and applications
expertise. An increasing number of businesses are choosing to
outsource the hosting and management of these applications.

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The trend towards outsourced hosting and
management of information technology infrastructure and
applications by middle-market organizations is driven by a
number of factors, including:



| |   |                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | developments by major hardware and software
    vendors that facilitate outsourcing;                                                                                                           
|
| |  | the need to improve the reliability, availability
    and overall performance of Internet-enabled applications as they
    increase in importance and complexity;                              
|
| |  | the need to focus on core business operations;                                                                                                                                                 
|
| |  | challenges and costs of hiring, training and
    retaining application engineers and information technology
    employees with the requisite range of information technology
    expertise; and
|
| |  | increasing complexity of managing the operations
    of Internet-enabled applications.                                                                                                         

Notwithstanding increasing demand for these
services, we believe the number of providers has decreased over
the past three years, primarily as a result of industry
consolidation and bankruptcies. We believe this consolidation
trend will continue and will benefit a small number of service
providers that have the resources and infrastructure to cost
effectively provide the scalability, performance, reliability
and business continuity that customers expect.

Our Strategy

Our goal is to become the leading provider of
outsourced managed hosting and managed application services for
middle-market organizations. Key elements of our strategy are to:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Deepen Existing Customer Relationships and
    Expand Our Customer Base.Most of our
    customers currently utilize only one of our service offerings.
    We plan to increase revenues with minimal additional costs by
    cross-selling our services to existing customers. We also plan
    to increase our customer base through direct sales and by
    expanding our channel relationships with key systems integrators
    and independent software vendors. For systems integrators, our
    flexibility and cost-effectiveness bolster their application
    development and management service. For independent software
    vendors, we provide the ability to offer their software as a
    managed service.
|
| | Improve Operating Margins Through
    Efficiencies.We have made significant
    improvements to our overall cost structure during the last
    twelve months. We intend to continue to improve operating
    margins as we improve the efficiency of our operations. As we
    grow, we will take advantage of our infrastructure capacity, our
    CAM platform and our automated processes. Due to the fixed cost
    nature of our infrastructure, increased customer revenue results
    in incremental improvements in our operating margins.                                                                                                                                                                       
|
| | Grow Through Disciplined
    Acquisitions.We intend to derive much
    of our future growth through acquisitions of technologies,
    products and companies that improve our services and strengthen
    our position in our target markets. By utilizing our expertise
    in acquiring and effectively integrating complementary
    companies, we can eliminate duplicative operations, reduce costs
    and improve our operating margins. We will acquire companies
    that provide valuable technical capabilities and entry into
    target markets, and allow us to take advantage of our existing
    technical and physical infrastructure.                                                                  
|
| | Emphasize and Invest in New High-Growth
    Service Areas.We plan to target
    emerging high growth service areas and increase the number of
    services we provide to our customers. These services include
    electronic software distribution and message archiving, as well
    as offering third-party enterprise software applications. As
    organizations become increasingly dependent on complex
    applications to run their businesses, we intend to provide
    technological innovation that will allow us to become an
    increasingly valuable provider to our customers.                                                                                                                          

Our Services

We offer our customers a broad range of managed
application, infrastructure and messaging services that can be
deployed quickly and cost effectively. Our management expertise
allows us to meet an expanding set of needs as our
customers applications become more complex. Our experience
and capabilities save our

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customers the time and cost of developing
expertise in-house and we increasingly serve as the sole manager
of our customers outsourced applications.


All of our service offerings can be customized to
meet our customers particular needs. Our proprietary CAM
platform enables us to offer valuable flexibility without the
significant costs associated with traditional customization.

Our services include:



| |                                              
| | ---------------------------------------------
| | Managed Application Services
    (A-Services)

Application Hosting
Services We provide fully
managed application hosting services. We manage data centers,
Internet connectivity, servers and networking, security
(including firewalls, virtual private networks and intrusion
detection), storage, load balancers, database clusters,
operating systems, and Web and application servers.

Application Management
Services We provide
application management services for leading databases and
complex software such as financial, enterprise resource
planning, supply chain management and customer relationship
management applications from software providers including
PeopleSoft, Microsoft, Oracle and Siebel. Application management
services are available in one of our data centers or via remote
management on a customers premises.

Application Development
Services We customize our
customers Web sites to enable them to share Web-based
information. Our development systems and software tools allow
our customers to update and access the back-end systems that
control and populate the data that updates their Web sites.



| |                                                 
| | ------------------------------------------------
| | Managed Infrastructure Services
    (I-Services)

Content and Electronic Software Distribution
Services Our content and
electronic software distribution services allow customers to
accelerate the distribution of Internet-based data to users
while reducing costs typically associated with this function.
Currently, our two primary areas of focus within this business
are our caching and acceleration services and our electronic
software distribution services.



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Our caching and acceleration services are
    specifically designed to bring Web content and information
    closer to the end user, which results in a decrease in overall
    bandwidth usage for the customer as well as an increase in
    overall performance regardless of the users Internet
    connection.                                                                                                                                                    
|
| |  | Our electronic software distribution services
    allow software manufacturers to securely and reliably distribute
    patches, updates, and even large new versions of their software
    products to users. This service decreases their software
    distribution costs and increases their ability to distribute
    updates quickly and accurately by permitting them to largely
    bypass traditional distribution processes such as shipping a
    compact disc.

Colocation
Services Our data centers
provide our colocation customers with a secure place to gain
rapid access to the Internet, without having to build their own
physical infrastructure. Our data centers include multiple
levels of security with camera surveillance, redundant
uninterruptible power supply, heating, ventilation and air
conditioning, monitored customer access 24 hours a day,
seven days a week, and advanced fire suppression.

Bandwidth
Services Our data centers
provide Internet connectivity via a wide range of network
providers and offer competitive bandwidth pricing.

Security
Services We offer industry
standard security services, including managed firewalls,
intrusion detection, denial of service attack prevention and
exposure analysis. For our security services, we utilize
software and hardware from vendors including Netscreen,
Checkpoint and Cisco.

Disaster Recovery
Services Features of our
disaster recovery program include back-up equipment, redundant
data centers for physical separation, tape back-up and off-site
archiving, storage on-demand, load balancing, fully replicated
data content, remote access, and professional consulting
services.

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| |                                            
| | -------------------------------------------
| | Managed Messaging Services
    (M-Services)

Our M-Services include the monitoring and
management of messaging applications, such as Microsoft Exchange
and Lotus Domino, allowing customers to outsource their critical
messaging applications. Customers can host their applications in
one of our data centers or keep their servers in their own
facility, which we monitor and manage remotely. In addition, our
customers can choose to utilize dedicated servers or shared
servers. We provide expert services to assist our customers with
the migration from legacy or proprietary messaging systems to
Microsoft Exchange or Lotus Domino. We also have expertise to
customize messaging and collaborative applications for our
customers. We offer user provisioning, spam filtering, virus
protection and enhanced monitoring and reporting.

We are developing managed messaging services
focused on allowing our customers to outsource other workplace
communication applications, including online collaboration,
business-class instant messaging, shared desktop and other
solutions.



| |                                                        
| | -------------------------------------------------------
| | Collaborative Application Management
    (CAM) Platform

Our proprietary CAM platform is a critical
element of each of our service offerings. Our CAM platform
allows us to work with our customers information
technology teams, systems integrators and other third parties to
provide our services to customers. Our CAM platform and its user
interface help ensure full transparency to the customer and
seamless operation of outsourced applications and
infrastructure, including: (i) hardware, operating system,
database and application monitoring; (ii) event management;
(iii) problem resolution management; and
(iv) integrated change and configuration management tools.
Our CAM platform includes:

Event Detection
System Our proprietary
technology allows our operations personnel to efficiently
process alerts across heterogeneous computing environments. This
system collects and aggregates data from all of the relevant
systems management software packages utilized by an information
technology organization.

Synthetic Transaction
Monitoring Our proprietary
synthetic transaction methods emulate the end-user experience
and monitor for application latency or malfunctions that affect
user productivity.

Automated
Remediation Our CAM
platform allows us to proactively monitor, identify and fix
common problems associated with the applications we manage on
behalf of our customers. These automated fixes help ensure
availability and reliability by remediating known issues in real
time, and keeping applications up and running while underlying
problems or potential problems are diagnosed.

Component Information
Manager This central
repository provides a unified view of disparate network,
database, application and hardware information.

Escalation
Manager This workflow
automation technology allows us to streamline routine tasks and
escalate critical issues in a fraction of the time that manual
procedures require. Escalation manager initiates specific orders
and tasks based on pre-defined conditions, ensuring clear,
consistent communications with our customers.

Our Infrastructure

Our infrastructure has been designed specifically
to meet the demanding technical requirements of providing our
services to our customers. We securely provide our services
across Windows, Unix and Linux platforms. We believe our
infrastructure, together with our trained and experienced staff,
enable us to offer market-leading levels of service backed by
high service level guarantees.

Network Operations
Centers We monitor the
operations of our infrastructure and customer applications from
our own state-of-the-art network operations centers. Network and
system management and monitoring tools continuously monitor our
network and server performance. Our network operations center
performs first-level problem identification, validation and
resolution. Our primary network operations center in Andover,
Massachusetts is staffed 24 hours a day, seven days a week
with network, security, Windows, Unix and Linux personnel. We
have technical support personnel located in our facilities in
San Jose, California;

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Syracuse, New York; and Houston, Texas, who
provide initial and escalated support, 24 hours a day,
seven days a week for our customers. Our engineers and support
personnel are promptly alerted to problems, and we have
established procedures for rapidly resolving any technical
issues that arise.


Data
Centers We currently have
14 data centers located in the United States and one data center
located in the United Kingdom. Our data centers incorporate
technically sophisticated components which are designed to be
fault-tolerant. The components used in our data centers include
redundant core routers, redundant core switching hubs and secure
virtual local area networks. We utilize the equipment and tools
necessary for our data center operations, including our
infrastructure hardware, networking and software products, from
industry leaders such as BMC, Cisco, Dell, EMC, Hewlett-Packard,
Microsoft, Oracle and Sun Microsystems.

Internet
Connectivity We have
redundant high-capacity Internet connections to Level 3,
Internap, WilTel and XO Communications. We have deployed direct
private transit and peering Internet connections to utilize the
providers peering capabilities and to enhance routes via
their networks to improve global performance. Our private
transit system enables us to provide fast, reliable access for
our customers information technology infrastructure and
applications.

Sales and Marketing

Direct
Sales Our direct sales
professionals are organized geographically in the United States
and the United Kingdom. Our sales teams meet with customers to
understand and identify their individual business requirements,
then translate those requirements into tailored services. Our
sales teams are also supported by customer relationship managers
who are assigned to specific accounts in order to identify and
take advantage of cross-selling opportunities. To date, most of
our sales have been realized through our direct sales force.

Channel
Relationships We also sell
our services through third parties, including IBM, Progress
Software application providers, SingTel and Accenture, pursuant
to reseller or referral contracts with such third parties. These
contracts are generally one to three years in length and provide
the reseller a discount of approximately 25% from our list price
or require us to pay a referral fee, typically ranging from
approximately 4% to 10% of the amounts we receive from the
customer. Typically, these third parties resell our services to
their customers under their private label brand or under the
NaviSite brand. In addition, we jointly market and sell our
services with the products of Progress Software. For systems
integrators, our flexibility and cost-effectiveness bolsters
their application development and management services. For
independent software vendors, we provide the opportunity to
offer their software as a managed service.

Marketing
Our marketing organization is responsible for defining and
executing our overall market strategy. Our demand generation
team focuses on identifying key market opportunities and
customer segments which will best match our service portfolio
and creates marketing programs which target those segments. We
are actively building general awareness of our company and our
strategy through public relations, marketing communications and
product marketing. The marketing organization supports direct
sales.

Customers

Our customers include mid-sized companies,
divisions of large multi-national companies and government
agencies. Our customers operate in a wide variety of industries,
such as technology, manufacturing, retail, business services and
government agencies.

We increased our customer base to approximately
1,150 customers as of July 31, 2004, including
approximately 148 customers through our sales channel
relationships, from approximately 700 customers as of
July 31, 2003, principally through acquisitions, an
increase in our product offering portfolio and increased market
demand.

We derived approximately 2% and 31% of our
revenue from CMGI and CMGI affiliates for the fiscal years ended
July 31, 2003 and 2002, respectively. During the fiscal
year ended July 31, 2004, revenue from CMGI and CMGI
affiliates was less than 1% of our total revenue.

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We derived approximately 12%, 21% and 0% of our
revenue from the New York State Department of Labor for the
fiscal years ended July 31, 2004, 2003 and 2002,
respectively. The contract with the New York State Department of
Labor is scheduled to expire in June 2005, but the New York
State Department of Labor has the right to terminate the
contract at any time by providing us with 60 days notice.
On November 25, 2003, we announced that the New York State
Department of Labor added $52 million to its existing
contract with us to provide application hosting and application
development services in support of the Americas Job Bank
Web site and related programs. This amendment to the existing
five-year, $83 million hosting and services contract also
decreased the hourly rates for various services that we provide
under the contract by an average of approximately 21%.
Americas Job Bank is a 20-year-old labor exchange network
developed and funded by the U.S. Department of Labor and
state employment service offices to link employers and job
seekers. The New York State Department of Labor has the ability
to purchase additional services to meet the projected contract
needs until the expiration of the contract in 2005.

Other than CMGI, CMGI affiliates and the New York
State Department of Labor, no other customer represented 10% or
more of our revenue for the fiscal years ended July 31,
2004, 2003 and 2002. Substantially all of our revenues are
derived from, and substantially all of our plant, property and
equipment are located in, the United States.

Competition

We compete in the managed hosting and application
services market, the managed infrastructure services market and
the managed messaging services market. These markets are
fragmented, highly competitive and likely to be characterized by
industry consolidation.

We believe that participants in these markets
must grow rapidly and achieve a significant presence to compete
effectively. We believe that the primary competitive factors
determining success in our markets include:



| |   |                                                                                                                                  
| | - | ---------------------------------------------------------------------------------------------------------------------------------
| |  | quality of service delivered;                                                                                                    
|
| |  | ability to consistently measure, track and report
    operational metrics;                                                       
|
| |  | application hosting, infrastructure and messaging
    management expertise;                                                      
|
| |  | fast, redundant and reliable Internet
    connectivity;                                                                          
|
| |  | a robust infrastructure providing availability,
    speed, scalability and security;                                             
|
| |  | comprehensive and diverse service offerings and
    timely addition of value-add services;                                       
|
| |  | brand recognition;                                                                                                               
|
| |  | strategic relationships;                                                                                                         
|
| |  | competitive pricing; and                                                                                                         
|
| |  | adequate capital to permit continued investment
    in infrastructure, customer service and support, and sales and
    marketing.

We believe that we compete effectively based on
our breadth of service offerings, the strength of our CAM
platform, our existing infrastructure capacity and our pricing.

Our current and prospective competitors include:



| |   |                                                                                                                                                                                                                                                                    
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | hosting and related services providers, including
    Data Return, LLC, Globix Corp., SAVVIS (which acquired the
    Cable & Wireless business including Exodus and Digital
    Island businesses), IBM, AT&T, and local and regional
    hosting providers;       
|
| |  | application services providers, such as Corio,
    Inc., USinternetworking, Inc. (USi) and Blue Star Systems, Inc.,
    a subsidiary of Affiliated Computer Services, Infocrossing,
    Inc., Electronic Data Systems Corp., and Computer Sciences
    Corporation;

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| |   |                                                                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | content and electronic software distribution
    providers, such as Akamai, Inc., Speedera Networks, Inc.,
    Digital River, Inc., and Intraware, Inc.;
|
| |  | colocation providers, including SAVVIS, Inflow,
    Inc., and Switch & Data Facilities Company,
    Inc.; and                                           
|
| |  | messaging providers, including Critical Path,
    Inc., Internoded, Inc., and USA.net, Inc.                                                             

Intellectual Property

We rely on a combination of trademark, service
mark, copyright and trade secret laws and contractual
restrictions to establish and protect our proprietary rights and
promote our reputation and the growth of our business. We do not
have any patents that would prevent or inhibit competitors from
using technology similar to ours or entering our market. While
it is our practice to require our employees, consultants and
independent contractors to enter into agreements containing
non-disclosure, non-competition (for employees only) and
non-solicitation restrictions and covenants, and while our
agreements with some of our customers and suppliers include
provisions prohibiting or restricting the disclosure of
proprietary information, we cannot assure you that these
contractual arrangements or the other steps taken by us to
protect our proprietary rights will prove sufficient to prevent
misappropriation of our proprietary rights or to deter
independent, third-party development of similar proprietary
assets. In addition, we offer our services in other countries
where the laws may not afford adequate protection for our
proprietary rights.

We license or lease most technologies used in our
hosting and application management services. Our technology
suppliers may become subject to third-party infringement claims,
or other claims or assertions, which could result in their
inability or unwillingness to continue to license their
technology to us. The loss of certain of our technologies could
impair our ability to provide services to our customers or
require us to obtain substitute technologies that may be of
lower quality or performance standards or at greater cost. We
expect that we and our customers increasingly will be subject to
third-party infringement claims as the number of Web sites and
third-party service providers for Internet-based businesses
grows. We cannot assure you that third parties will not assert
claims alleging the infringement of service marks and trademarks
against us in the future or that these claims will not be
successful. Any infringement claim as to our technologies or
services, regardless of its merit, could be time-consuming,
result in costly litigation, cause delays in service,
installation or upgrades, adversely impact our relationships
with suppliers or customers or require us to enter into costly
royalty or licensing agreements.

Government Regulation

While there currently are few laws or regulations
directly applicable to the Internet or to managed application
hosting service providers, due to the increasing popularity of
the Internet and Internet-based applications, such laws and
regulations are being considered and may be adopted. These laws
may cover a variety of issues including, for example, user
privacy and the pricing, characteristics and quality of products
and services. The adoption or modification of laws or
regulations relating to commerce over the Internet could
substantially impair the future growth of our business or expose
us to unanticipated liabilities. Moreover, the applicability of
existing laws to the Internet and managed application hosting
service providers is uncertain. These existing laws could expose
us to substantial liability if they are found to be applicable
to our business. For example, we offer services over the
Internet in many states in the United States and internationally
and we facilitate the activities of our customers in those
jurisdictions. As a result, we may be required to qualify to do
business, be subject to taxation or be subject to other laws and
regulations in these jurisdictions, even if we do not have a
physical presence or employees or property there. The
application of existing laws and regulations to the Internet or
our business, or the adoption of any new legislation or
regulations applicable to the Internet or our business, could
materially adversely affect our financial condition and
operating results.

Employees

As of July 31, 2004, we had 559 employees.
Of these employees, 387 were principally engaged in operations,
80 were principally engaged in sales and marketing and 92 were
principally engaged in general and

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administration. None of our employees is party to
a collective bargaining agreement, and we believe our
relationship with our employees is good. We also retain
consultants and independent contractors on a regular basis to
assist in the completion of projects.


Available Information

We make our annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on
Form 8-K and amendments to those reports available through
our Web site, free of charge, as soon as reasonably practicable
after we file such material with, or furnish it to the
Securities and Exchange Commission. Our Internet address is
http://www.navisite.com. The contents of our Web site are not
part of this annual report on Form 10-K, and our Internet
address is included in this document as an inactive textual
reference only.

Certain Risk Factors That May Affect Future
Results

We operate in a rapidly changing environment
that involves a number of risks, some of which are beyond our
control. Forward looking statements in this report and those
made from time to time by us through our senior management are
made pursuant to the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Forward looking
statements concerning the expected future revenues, earnings or
financial results or concerning project plans, performance, or
development of products and services, as well as other estimates
related to future operations are necessarily only estimates of
future results and there can be no assurance that actual results
will not materially differ from expectations. Forward-looking
statements represent managements current expectations and
are inherently uncertain. We do not undertake any obligation to
update forward-looking statements. If any of the following risks
actually occurs, our financial condition and operating results
could be materially adversely affected.

We have a history of losses and may never
achieve or sustain profitability and may not continue as a going
concern.We have never been
profitable and may never become profitable. Since our
incorporation in 1998, we have experienced operating losses and
negative operating cash flows for each quarterly and annual
period. As of July 31, 2004, we had incurred losses since
our incorporation resulting in an accumulated deficit of
approximately $439.9 million. During the fiscal year ended
July 31, 2004, we had a net loss of approximately
$21.4 million. The audit report from KPMG LLP, our
independent auditors, relating to our fiscal year 2004 financial
statements contains KPMGs opinion that our recurring
losses from operations since inception and accumulated deficit,
as well as other factors, raise substantial doubt about our
ability to continue as a going concern. We anticipate that we
will continue to incur net losses in the future. We also have
significant fixed commitments, including with respect to real
estate, bandwidth commitments, machinery and equipment leases.
As a result, we can give no assurance that we will achieve
profitability or be capable of sustaining profitable operations.
If we are unable to reach and sustain profitability, we risk
depleting our working capital balances and our business may not
continue as a going concern.

We need to obtain additional financing,
which may not be available on favorable terms, or at
all.As of July 31, 2004 we
had approximately $3.2 million of cash and cash equivalents
and a working capital deficit of approximately
$36.7 million. Our outstanding balance under our Silicon
Valley Bank amended accounts receivable financing agreement as
of July 31, 2004 was $20.4 million. We need to raise
additional capital and such capital may not be available on
favorable terms or at all. On January 22, 2004, we filed
with the Securities and Exchange Commission a Registration
Statement on Form S-2 to register shares of our common
stock to issue and sell in a public offering to raise additional
funds. In the event we are not successful in raising capital
through this public offering, we will be required to expense
$0.7 million of associated offering expenses which are
presently included in prepaid expenses and other current assets
on our July 31, 2004 Consolidated Balance Sheet. If we do
not raise additional capital, our business may not continue as a
going concern.

Our projections for cash usage are based on a
number of assumptions, including our ability to:



| |   |                                                                                
| | - | -------------------------------------------------------------------------------
| |  | retain customers in light of market uncertainties
    and our uncertain future;
|
| |  | collect accounts receivables in a timely manner;                               

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| |   |                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------
| |  | effectively integrate Surebridge and other recent
    acquisitions and realize forecasted cash savings; and
|
| |  | achieve other expected cash expense reductions.                                                            

Further, our projected use of cash and business
results could be affected by continued market uncertainties,
including delays or restrictions in information technology
spending by customers or potential customers and any merger or
acquisition activity.

In recent years, we have generally financed our
operations with proceeds from selling shares of our stock and
borrowing funds. There can be no assurance that additional
financing will be available on favorable terms, or at all. In
addition, even if we find outside funding sources, we may be
required to issue securities with greater rights than those
currently possessed by holders of our common stock. We may also
be required to take other actions that may lessen the value of
our common stock or dilute our common stockholders, including
borrowing money on terms that are not favorable to us or issuing
additional equity securities. If we experience difficulties
raising money in the future, our business and liquidity will be
materially adversely affected.

We may not realize all of the anticipated
benefits of our recent acquisition of
Surebridge.On June 10, 2004,
pursuant to an asset purchase agreement dated May 6, 2004,
we completed the acquisition of substantially all of the assets
and liabilities of Surebridge for three million shares of our
common stock, two promissory notes in the aggregate principal
amount of approximately $39.3 million and the assumption of
certain liabilities.

The success of the acquisition depends, in part,
on our ability to realize the anticipated synergies, cost
savings and growth and marketing opportunities from integrating
the businesses of Surebridge with the businesses of NaviSite.
Our success in realizing these benefits and the timing of this
realization depend upon the successful integration of the
technology, personnel and operations of Surebridge. The
integration of two independent companies is a complex, costly
and time-consuming process. The difficulties of combining the
operations of the companies include, among others:



| |   |                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------
| |  | retaining key employees;                                                                                                                      
|
| |  | consolidating corporate and administrative
    infrastructures;                                                                               
|
| |  | maintaining customer service levels;                                                                                                          
|
| |  | coordinating sales and marketing functions;                                                                                                   
|
| |  | preserving the distribution, marketing, promotion
    and other important internal operations and third-party
    relationships of Surebridge;
|
| |  | minimizing the diversion of managements
    attention from our current business;                                                             
|
| |  | coordinating geographically disparate
    organizations and data centers; and                                                                 
|
| |  | retaining key customers.                                                                                                                      

There can be no assurance that the integration of
Surebridge with NaviSite will result in the realization of the
full benefits that we anticipate in a timely manner or at all.

The convertible promissory notes we issued
in the Surebridge acquisition may negatively affect our
liquidity and our ability to obtain additional financing and
operate and manage our business.On June 10, 2004, in connection with our acquisition of the
Surebridge business, we issued two convertible promissory notes
in the aggregate principal amount of approximately
$39.3 million. We must repay the outstanding principal of
the notes with all interest accrued thereon, no later than
June 10, 2006. In addition, if at any time during the first
six months after the date of the notes we complete certain
equity or debt financings, including our proposed public
offering, we are obligated to use a significant portion of the
proceeds to make payments on the notes, depending on the total
net proceeds received by us in the financing. If we receive net
proceeds of less than $20.0 million in a debt or equity
financing, then we would be obligated to make a payment on the
notes equal to 75% of the net proceeds. If we receive net
proceeds of between $20.0 million and $30.0 million,
then we would be obligated to make a payment on the notes equal
to $15.0 million. If we receive net proceeds

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in excess of $30.0 million, then we would be
obligated to make a payment on the notes equal to 50% of the net
proceeds.


In addition, if we realize net proceeds in excess
of $1.0 million from certain equity or debt financings or
sales of assets at any time after six months from the date the
notes were issued, we are obligated to use a significant portion
of the proceeds to make payments on the notes, depending on the
total payments, if any, made on the notes during the first six
months after the notes were issued. If the amount we paid on the
notes during the first six months the notes were outstanding is
less than $10.0 million, we would be obligated to make a
payment on the notes equal to 75% of the net proceeds. If the
amount we paid on the notes during the first six months the
notes were outstanding was greater than $15.0 million, we
would be obligated to make a payment on the notes equal to 50%
of the net proceeds. If the amount we paid on the notes during
the first six months the notes were outstanding is between
$10.0 million and $15.0 million, we would be obligated
to make a payment on the notes equal to a percentage between 50%
and 75% of the net proceeds received in the financing, such
percentage to be calculated in accordance with a formula set
forth in the notes.

The notes, or the prepayment obligation thereon,
may adversely affect our ability to raise or retain additional
capital. If we commit an event of default under any of the
promissory notes, which may include a default of obligations
owed to other third parties, prior to the respective maturity
dates of the promissory notes, then the holders of the
promissory notes may declare the notes immediately due and
payable, which would adversely affect our liquidity and our
ability to manage our business. Furthermore, the promissory
notes contain certain restrictive covenants, including with
respect to our ability to incur indebtedness.

Our common stockholders may suffer
significant dilution in the future upon the conversion of
outstanding securities and the issuance of additional securities
in potential future acquisitions.The outstanding principal and accrued interest on the two
Surebridge promissory notes shall be convertible into shares of
our common stock at a conversion price of $4.642, at the
election of the holder:



| |   |                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | at any time following the first anniversary of
    the closing if the aggregate principal outstanding under the
    notes at such time is greater than or equal to
    $20.0 million;   
|
| |  | at any time following the 18-month anniversary of
    the closing if the aggregate principal outstanding under the
    notes at such time is greater than or equal to
    $10.0 million;
|
| |  | at any time following the second anniversary of
    the closing; and                                                                                                                    
|
| |  | at any time following an event of default
    thereunder.                                                                                                                               

If the promissory notes are converted into shares
of common stock, Surebridge may obtain a significant equity
interest in NaviSite and other stockholders may experience
significant and immediate dilution. Should Surebridge elect to
convert all of the initial principal amount of its two
convertible promissory notes into shares of our common stock,
Surebridge would own approximately 11,466,000 shares of our
common stock, which, based on our capitalization as of
September 30, 2004, would be approximately 32% of our
outstanding shares of common stock.

In addition, our stockholders will experience
further dilution to the extent that additional shares of our
common stock are issued in potential future acquisitions.

Our financing agreement with Silicon Valley
Bank includes various covenants and restrictions that may
negatively affect our liquidity and our ability to operate and
manage our business.As of
July 31, 2004, we owed Silicon Valley Bank approximately
$20.4 million under our amended accounts receivable
financing agreement. The accounts receivable financing agreement
generally restricts or limits, among other things, our ability
to:



| |   |                                                                              
| | - | -----------------------------------------------------------------------------
| |  | create or incur indebtedness;                                                
|
| |  | sell, or permit any lien or security interest in,
    any of our assets;     
|
| |  | enter into or permit any material transaction
    with any of our affiliates;

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| |   |                                                                                                                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | merge or consolidate with any other party, or
    acquire all or substantially all of the capital stock or
    property of another party, unless, among other things, the other
    party is in the same, or a similar line of business as us;
|
| |  | relocate our principal executive office or add
    any new offices or business locations;                                                                                                                                                     
|
| |  | change our state of formation;                                                                                                                                                                                                                
|
| |  | change our legal name;                                                                                                                                                                                                                        
|
| |  | make investments;                                                                                                                                                                                                                             
|
| |  | pay dividends or make any distribution or payment
    or redeem, retire or purchase our capital stock; and                                                                                                                                    
|
| |  | make or permit any payment on subordinated debt
    or amend any provision in any document relating to any
    subordinated debt.                                                                                                             

Further, the accounts receivable financing
agreement requires that we maintain EBITDA of at least $1.00 for
every fiscal quarter. The agreement defines EBITDA as earnings
before interest, taxes, depreciation and amortization in
accordance with generally accepted accounting principles and
excluding acquisition-related costs and one-time extraordinary
charges.

If we breach our accounts receivable financing
agreement with Silicon Valley Bank, which may be deemed to have
occurred upon an event of default under the promissory notes
issued in the Surebridge transaction, a default could result. A
default, if not waived, could result in, among other things, us
not being able to borrow additional amounts from Silicon Valley
Bank and all or a portion of our outstanding amounts may become
due and payable on an accelerated basis, which would adversely
affect our liquidity and our ability to manage our business. A
default under the accounts receivable financing agreement could
also result in a cross-default under the promissory notes issued
in the Surebridge transaction thereby accelerating the repayment
obligation on the notes and also allowing the holder to elect to
convert the principal and accrued interest thereon into shares
of our common stock.

Our limited operating history with our
current operating structure makes it difficult for us and our
investors to evaluate our past performance and future
prospects.We have completed a
number of acquisitions since December 2002. Until a significant
period of time elapses, it will be difficult to determine if we
correctly valued these acquired businesses or adequately
anticipated all of the demands that our growth will impose on
our personnel, procedures and structures, including our
financing and reporting control systems and management
structure. Our limited operating history with our current
structure makes it very difficult for you and us to evaluate or
predict our ability to, among other things, retain customers,
generate and sustain a revenue base sufficient to meet our
operating expenses, and achieve and sustain profitability.

A significant portion of our revenue comes
from one customer and, if we lost this customer, it would have a
significant adverse impact on our business results and cash
flows.The New York State
Department of Labor represented approximately 12% of our
consolidated revenue for the fiscal year ended July 31,
2004. The New York State Department of Labor has been a
long-term customer of ours, but there can be no assurance that
we will be able to retain this customer. Further, there can be
no assurance that we will be able to maintain the same level of
service to this customer or that our revenue from this customer
will not decline or suffer a material reduction in future
periods. The New York State Department of Labor is not obligated
under our agreement to buy a minimum amount of services from us
or designate us as its sole supplier of any particular service.
This contract with The New York State Department of Labor, and
its funding allowance, expires in June 2005. Further, The New
York State Department of Labor has the right to terminate this
contract at any time by providing us with 60 days notice.
If we were to lose this customer or suffer a material reduction
in the revenue generated from this customer, it would have a
significant adverse impact on our business results and cash
flows.

Atlantic Investors may have interests that
conflict with the interests of our other stockholders and, as
our majority stockholder, can prevent new and existing investors
from influencing significant corporate
decisions.Atlantic Investors owns
approximately 61% of our outstanding capital stock as of
September 30, 2004. In

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addition, Atlantic Investors holds a note in the
principal amount of $3.0 million due upon the earlier to
occur of February 1, 2005, and five business days after our
receipt of net proceeds from a financing or a sale of assets of
at least $13.0 million, after satisfying the mandatory
prepayment obligations under the promissory notes issued to
Surebridge. Atlantic Investors has the power, acting alone, to
elect a majority of our Board of Directors and has the ability
to control our management and affairs and determine the outcome
of any corporate action requiring stockholder approval,
regardless of how our other stockholders may vote, including the
election of directors, any merger, consolidation or sale of all
or substantially all of our assets, and any other significant
corporate transaction. Under Delaware law, Atlantic Investors is
able to exercise its voting power by written consent, without
convening a meeting of the stockholders, which means that
Atlantic Investors could effect a sale or merger of us without
the consent of our other stockholders. Atlantic Investors
ownership of a majority of our outstanding common stock may have
the effect of delaying, deterring or preventing a change in
control of us or discouraging a potential acquiror from
attempting to obtain control of us, which in turn could
adversely affect the market price of our common stock.


Members of our management group also have
significant interests in Atlantic Investors, which may create
conflicts of interest.Some of the
members of our management group also serve as members of the
management group of Atlantic Investors and its affiliates.
Specifically, Andrew Ruhan, our Chairman of the Board, holds a
10% equity interest in Unicorn Worldwide Holdings Limited, a
managing member of Atlantic Investors. Arthur Becker, our
President and Chief Executive Officer, is the managing member of
Madison Technology LLC, a managing member of Atlantic Investors.
As a result, these NaviSite officers and directors may face
potential conflicts of interest with each other and with our
stockholders. They may be presented with situations in their
capacity as our officers or directors that conflict with their
fiduciary obligations to Atlantic Investors, which in turn may
have interests that conflict with the interests of our other
stockholders.

Acquisitions may result in disruptions to
our business or distractions of our management due to
difficulties in integrating acquired personnel and operations,
and these integrations may not proceed as
planned.Since December 2002, we
have acquired ClearBlue Technologies Management, Inc., or CBTM
(accounted for as an as if pooling), Avasta,
Conxion, selected assets of Interliant, all of the shares of ten
wholly-owned subsidiaries of ClearBlue Technologies, Inc., or
CBT (accounted for as an as if pooling), and
substantially all of the assets and liabilities of Surebridge.
We intend to continue to expand our business through the
acquisition of companies, technologies, products and services.
Acquisitions involve a number of special problems and risks,
including:



| |   |                                                                                                                                                                                                                           
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | difficulty integrating acquired technologies,
    products, services, operations and personnel with the existing
    businesses;                                                                                          
|
| |  | difficulty maintaining relationships with
    important third parties, including those relating to marketing
    alliances and providing preferred partner status and favorable
    pricing;                              
|
| |  | diversion of managements attention in
    connection with both negotiating the acquisitions and
    integrating the businesses;                                                                                          
|
| |  | strain on managerial and operational resources as
    management tries to oversee larger operations;                                                                                                                      
|
| |  | inability to retain and motivate management and
    other key personnel of the acquired businesses;                                                                                                                       
|
| |  | changes in management and key personnel of
    acquired businesses may harm relationships with the acquired
    businesses customers, suppliers and employees;                                                           
|
| |  | exposure to unforeseen liabilities of acquired
    companies;                                                                                                                                                             
|
| |  | potential costly and time-consuming litigation,
    including stockholder lawsuits;                                                                                                                                       
|
| |  | potential issuance of securities in connection
    with an acquisition with rights that are superior to the rights
    of holders of our common stock, or which may have a dilutive
    effect on our common stockholders;
|
| |  | the need to incur additional debt or use
    cash; and                                                                                                                                                                    

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| |   |                                                                                                                                       
| | - | --------------------------------------------------------------------------------------------------------------------------------------
| |  | the requirement to record potentially significant
    additional future operating costs for the amortization of
    intangible assets.

As a result of these problems and risks,
businesses we acquire may not produce the revenues, earnings or
business synergies that we anticipated, and acquired products,
services or technologies might not perform as we expected. As a
result, we may incur higher costs and realize lower revenues
than we had anticipated. We may not be able to successfully
address these problems and we cannot assure you that the
acquisitions will be successfully identified and completed or
that, if acquisitions are completed, the acquired businesses,
products, services or technologies will generate sufficient
revenue to offset the associated costs or other harmful effects
on our business.

A failure to meet customer specifications
or expectations could result in lost revenues, increased
expenses, negative publicity, claims for damages and harm to our
reputation and cause demand for our services to
decline.Our agreements with
customers require us to meet specified service levels for the
services we provide. In addition, our customers may have
additional expectations about our services. Any failure to meet
customers specifications or expectations could result in:



| |   |                                                                                                                                                                                                                                           
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | delayed or lost revenue;                                                                                                                                                                                                                  
|
| |  | requirements to provide additional services to a
    customer at reduced charges or no charge;                                                                                                                                            
|
| |  | negative publicity about us, which could
    adversely affect our ability to attract or retain
    customers; and                                                                                                                         
|
| |  | claims by customers for substantial damages
    against us, regardless of our responsibility for such failure,
    which may not be covered by insurance policies and which may not
    be limited by contractual terms of our engagement.

Our ability to successfully market our
services could be substantially impaired if we are unable to
deploy new infrastructure systems and applications or if new
infrastructure systems and applications deployed by us prove to
be unreliable, defective or
incompatible.We may experience
difficulties that could delay or prevent the successful
development, introduction or marketing of hosting and
application management services in the future. If any newly
introduced infrastructure systems and applications suffer from
reliability, quality or compatibility problems, market
acceptance of our services could be greatly hindered and our
ability to attract new customers could be significantly reduced.
We cannot assure you that new applications deployed by us will
be free from any reliability, quality or compatibility problems.
If we incur increased costs or are unable, for technical or
other reasons, to host and manage new infrastructure systems and
applications or enhancements of existing applications, our
ability to successfully market our services could be
substantially limited.

Any interruptions in, or degradation of,
our private transit Internet connections could result in the
loss of customers or hinder our ability to attract new
customers.Our customers rely on
our ability to move their digital content as efficiently as
possible to the people accessing their Web sites and
infrastructure systems and applications. We utilize our direct
private transit Internet connections to major network providers,
such as Level 3, Internap, WilTel and XO Communications, as
a means of avoiding congestion and resulting performance
degradation at public Internet exchange points. We rely on these
telecommunications network suppliers to maintain the operational
integrity of their networks so that our private transit Internet
connections operate effectively. If our private transit Internet
connections are interrupted or degraded, we may face claims by,
or lose, customers, and our reputation in the industry may be
harmed, which may cause demand for our services to decline.

If we are unable to maintain existing and
develop additional relationships with software vendors, the
sales and marketing of our service offerings may be
unsuccessful.We believe that to
penetrate the market for hosting and application management
services we must maintain existing and develop additional
relationships with industry-leading software vendors. We license
or lease select software applications from software vendors,
including IBM, Microsoft, Micromuse and Oracle. Our
relationships with Microsoft and PeopleSoft are critical to the
operations and success of our recently acquired business from
Surebridge. The loss of our ability to continually obtain,
utilize or depend on any of these applications or relationships
could substantially weaken our ability to provide services to
our customers or require us to obtain substitute software
applications that

17



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may be of lower quality or performance standards
or at greater cost. In addition, because we generally license
applications on a non-exclusive basis, our competitors may
license and utilize the same software applications. In fact,
many of the companies with which we have strategic relationships
currently have, or could enter into, similar license agreements
with our competitors or prospective competitors. We cannot
assure you that software applications will continue to be
available to us from software vendors on commercially reasonable
terms. If we are unable to identify and license software
applications that meet our targeted criteria for new application
introductions, we may have to discontinue or delay introduction
of services relating to these applications.


Our network infrastructure could fail,
which would impair our ability to provide guaranteed levels of
service and could result in significant operating
losses.To provide our customers
with guaranteed levels of service, we must operate our network
infrastructure 24 hours a day, seven days a week without
interruption. We must, therefore, protect our network
infrastructure, equipment and customer files against damage from
human error, natural disasters, unexpected equipment failure,
power loss or telecommunications failures, terrorism, sabotage
or other intentional acts of vandalism. Even if we take
precautions, the occurrence of a natural disaster, equipment
failure or other unanticipated problem at one or more of our
data centers could result in interruptions in the services we
provide to our customers. We cannot assure you that our disaster
recovery plan will address all, or even most, of the problems we
may encounter in the event of a disaster or other unanticipated
problem. We have experienced service interruptions in the past,
and any future service interruptions could:



| |   |                                                                                                                                
| | - | -------------------------------------------------------------------------------------------------------------------------------
| |  | require us to spend substantial amounts of money
    to replace equipment or facilities;                                       
|
| |  | entitle customers to claim service credits or
    seek damages for losses under our service level guarantees;                  
|
| |  | cause customers to seek alternate
    providers; or                                                                            
|
| |  | impede our ability to attract new customers,
    retain current customers or enter into additional strategic
    relationships.

Our dependence on third parties increases
the risk that we will not be able to meet our customers
needs for software, systems and services on a timely or
cost-effective basis, which could result in the loss of
customers.Our services and
infrastructure rely on products and services of third-party
providers. We purchase key components of our infrastructure,
including networking equipment, from a limited number of
suppliers, such as IBM, Cisco Systems and F5 Networks. Our
recently acquired business from Surebridge relies on products
and services of Microsoft and PeopleSoft. There can be no
assurance that we will not experience operational problems
attributable to the installation, implementation, integration,
performance, features or functionality of third-party software,
systems and services. We cannot assure you that we will have the
necessary hardware or parts on hand or that our suppliers will
be able to provide them in a timely manner in the event of
equipment failure. Our ability to obtain and continue to
maintain the necessary hardware or parts on a timely basis could
result in sustained equipment failure and a loss of revenue due
to customer loss or claims for service credits under our service
level guarantees.

We could be subject to increased operating
costs, as well as claims, litigation or other potential
liability, in connection with risks associated with Internet
security and the security of our
systems.A significant barrier to
the growth of e-commerce and communications over the Internet
has been the need for secure transmission of confidential
information. Several of our infrastructure systems and
application services utilize encryption and authentication
technology licensed from third parties to provide the
protections necessary to ensure secure transmission of
confidential information. We also rely on security systems
designed by third parties and the personnel in our network
operations centers to secure those data centers. Any
unauthorized access, computer viruses, accidental or intentional
actions and other disruptions could result in increased
operating costs. For example, we may incur additional
significant costs to protect against these interruptions and the
threat of security breaches or to alleviate problems caused by
such interruptions or breaches. Further, we expect to continue
to invest in and expend additional financial resources to equip
our data centers with enhanced security measures. If a third
party were able to misappropriate a consumers personal or
proprietary information, including credit card information,
during the use of an application solution provided by us, we
could be subject to claims, litigation or other potential
liability.

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Third-party infringement claims against our
technology suppliers, customers or us could result in
disruptions in service, the loss of customers or costly and
time-consuming litigation.We
license or lease most technologies used in the infrastructure
systems and application services that we offer. Our technology
suppliers may become subject to third-party infringement or
other claims and assertions, which could result in their
inability or unwillingness to continue to license their
technologies to us. We cannot assure you that third parties will
not assert claims against us in the future or that these claims
will not be successful. Any infringement claim as to our
technologies or services, regardless of its merit, could result
in delays in service, installation or upgrades, the loss of
customers or costly and time-consuming litigation.

We may be subject to legal claims in
connection with the information disseminated through our
network, which could divert managements attention and
require us to expend significant financial
resources.We may face potential
direct and indirect liability for claims of defamation,
negligence, copyright, patent or trademark infringement and
other claims based on the nature and content of the materials
disseminated through our network. For example, lawsuits may be
brought against us claiming that content distributed by some of
our current or future customers may be regulated or banned. In
these and other instances, we may be required to engage in
protracted and expensive litigation that could have the effect
of diverting managements attention from our business and
require us to expend significant financial resources. Our
general liability insurance may not cover any of these claims or
may not be adequate to protect us against all liability that may
be imposed. In addition, on a limited number of occasions in the
past, businesses, organizations and individuals have sent
unsolicited commercial e-mails from servers hosted at our
facilities to a number of people, typically to advertise
products or services. This practice, known as
spamming, can lead to statutory liability as well as
complaints against service providers that enable such
activities, particularly where recipients view the materials
received as offensive. We have in the past received, and may in
the future receive, letters from recipients of information
transmitted by our customers objecting to such transmission.
Although we prohibit our customers by contract from spamming, we
cannot assure you that our customers will not engage in this
practice, which could subject us to claims for damages.

If we fail to attract or retain key
officers, management and technical personnel, our ability to
successfully execute our business strategy or to continue to
provide services and technical support to our customers could be
adversely affected and we may not be successful in attracting
new customers.We believe that
attracting, training, retaining and motivating technical and
managerial personnel, including individuals with significant
levels of infrastructure systems and application expertise, is a
critical component of the future success of our business.
Qualified technical personnel are likely to remain a limited
resource for the foreseeable future and competition for these
personnel is intense. The departure of any of our executive
officers, particularly Arthur P. Becker, our Chief Executive
Officer and President, or core members of our sales and
marketing teams or technical service personnel, would have
negative ramifications on our customer relations and operations,
including adversely affecting the stability of our
infrastructure and our ability to provide the guaranteed service
levels our customers expect. Any officer or employee can
terminate his or her relationship with us at any time. In
addition, we do not carry life insurance on any of our
personnel. Over the past two years, we have had significant
reductions-in-force due to redundancies and restructurings
resulting from the consolidation of our acquired companies. We
have also had a number of departures of several members of
senior management due primarily to the change of control of
NaviSite on September 11, 2002. In the event future
reductions or departures of employees occur, our ability to
successfully execute our business strategy, or to continue to
provide services to our customers or attract new customers,
could be adversely affected.

The unpredictability of our quarterly
results may cause the trading price of our common stock to
fluctuate or decline.Our
quarterly operating results may vary significantly from
quarter-to-quarter and period-to-period as a result of a number
of factors, many of which are outside of our control and any one
of which may cause our stock price to fluctuate. The primary
factors that may affect our operating results include the
following:



| |   |                                                                                 
| | - | --------------------------------------------------------------------------------
| |  | reduction of market demand and/or acceptance of
    our services;               
|
| |  | oversupply of data center space in the industry;                                
|
| |  | our ability to develop, market and introduce new
    services on a timely basis;

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| |   |                                                                                                 
| | - | ------------------------------------------------------------------------------------------------
| |  | the length of the sales cycle for our services;                                                 
|
| |  | the timing and size of sales of our services,
    which depends on the budgets of our customers;
|
| |  | downward price adjustments by our competitors;                                                  
|
| |  | changes in the mix of services provided by our
    competitors;                                 
|
| |  | technical difficulties or system downtime
    affecting the Internet or our hosting operations; 
|
| |  | our ability to meet any increased technological
    demands of our customers; and               
|
| |  | the amount and timing of costs related to our
    marketing efforts and service introductions.  

Due to the above factors, we believe that
quarter-to-quarter or period-to-period comparisons of our
operating results may not be a good indicator of our future
performance. Our operating results for any particular quarter
may fall short of our expectations or those of stockholders or
securities analysts. In this event, the trading price of our
common stock would likely fall.

If we are unsuccessful in pending and
potential litigation matters, our financial condition may be
adversely affected.We are
currently involved in various pending and potential legal
proceedings, including a class action lawsuit related to our
initial public offering, an arbitration matter involving the
former stockholders of Avasta, counterclaims by the defendant in
a suit in which we are the plaintiff, and a payment demand by an
investment bank. If we are ultimately unsuccessful in any of
these matters, we could be required to pay substantial amounts
of cash and/or shares of our common stock to the other parties.
The amount and timing of any such payments could adversely
affect our financial condition.

If the markets for outsourced information
technology infrastructure and applications, Internet commerce
and communication decline, there may be insufficient demand for
our services and, as a result, our business strategy and
objectives may fail.The increased
use of the Internet for retrieving, sharing and transferring
information among businesses and consumers is developing, and
the market for the purchase of products and services over the
Internet is still relatively new and emerging. Our industry has
experienced periods of rapid growth, followed by a sharp decline
in demand for products and services, which related to the
failure in the last few years of many companies focused on
developing Internet-related businesses. If acceptance and growth
of the Internet as a medium for commerce and communication
declines, our business strategy and objectives may fail because
there may not be sufficient market demand for our hosting and
application management services.

If we do not respond to rapid changes in
the technology sector, we will lose
customers.The markets for the
technology-related services we offer are characterized by
rapidly changing technology, evolving industry standards,
frequent new service introductions, shifting distribution
channels and changing customer demands. We may not be able to
adequately adapt our services or to acquire new services that
can compete successfully. In addition, we may not be able to
establish and maintain effective distribution channels. We risk
losing customers to our competitors if we are unable to adapt to
this rapidly evolving marketplace.

The market in which we operate is highly
competitive and is likely to consolidate, and we may lack the
financial and other resources, expertise or capability needed to
capture increased market share or maintain market
share.We compete in the hosting
and application management services market. This market is
rapidly evolving, highly competitive and likely to be
characterized by over-capacity and industry consolidation. Our
competitors may consolidate with one another or acquire software
application vendors or technology providers, enabling them to
more effectively compete with us. Many participants in this
market have suffered significantly in the last several years. We
believe that participants in this market must grow rapidly and
achieve a significant presence to compete effectively. This
consolidation could affect prices and other competitive factors
in ways that would impede our ability to compete successfully in
the hosting and application management services market.

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Further, our business is not as developed as that
of many of our competitors. Many of our competitors have
substantially greater financial, technical and market resources,
greater name recognition and more established relationships in
the industry. Many of our competitors may be able to:



| |   |                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------
| |  | develop and expand their network infrastructure
    and service offerings more rapidly;                                             
|
| |  | adapt to new or emerging technologies and changes
    in customer requirements more quickly;                                        
|
| |  | take advantage of acquisitions and other
    opportunities more readily; or                                                         
|
| |  | devote greater resources to the marketing and
    sale of their services and adopt more aggressive pricing
    policies than we can.

We may lack the financial and other resources,
expertise or capability needed to maintain or capture increased
market share in this environment in the future. Because of these
competitive factors and due to our comparatively small size and
our lack of financial resources, we may be unable to
successfully compete in the hosting and application management
services market.

The emergence and growth of a market for
our hosting and managed application services will be impaired if
third parties do not continue to develop and improve Internet
infrastructure.The recent growth
in the use of the Internet has caused frequent periods of
performance degradation, requiring the upgrade of routers and
switches, telecommunications links and other components forming
the infrastructure of the Internet. Any perceived degradation in
the performance of the Internet as a means to transact business
and communicate could undermine the benefits and market
acceptance of our services. Consequently, the market for our
services will be impaired if improvements are not made to the
entire Internet infrastructure to alleviate overloading and
congestion.

Difficulties presented by international
economic, political, legal, accounting and business factors
could harm our business in international
markets.We operate a data center
in the United Kingdom and revenue from our foreign operations
accounted for approximately 8% of our total revenue during the
fiscal year ended July 31, 2004. Although we expect to
focus most of our growth efforts in the United States, we may
enter into joint ventures or outsourcing agreements with third
parties, acquire complementary businesses or operations, or
establish and maintain new operations outside of the United
States. Some risks inherent in conducting business
internationally include:



| |   |                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------
| |  | unexpected changes in regulatory, tax and
    political environments;                                                                              
|
| |  | longer payment cycles and problems collecting
    accounts receivable;                                                                             
|
| |  | geopolitical risks such as political and economic
    instability and the possibility of hostilities among countries;                              
|
| |  | reduced protection of intellectual property
    rights;                                                                                            
|
| |  | fluctuations in currency exchange rates;                                                                                                           
|
| |  | our ability to secure and maintain the necessary
    physical and telecommunications infrastructure;                                               
|
| |  | challenges in staffing and managing foreign
    operations;                                                                                        
|
| |  | employment laws and practices in foreign
    countries; and                                                                                        
|
| |  | laws and regulations on content distributed over
    the Internet that are more restrictive than those currently in
    place in the United States.

Any one or more of these factors could adversely
affect our contemplated future international operations and
consequently, our business.

We may become subject to burdensome
government regulation and legal uncertainties that could
substantially harm our business or expose us to unanticipated
liabilities.It is likely that
laws and regulations directly applicable to the Internet or to
hosting and managed application service providers may be
adopted. These laws may cover a variety of issues, including
user privacy and the pricing, characteristics and quality of

21



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products and services. The adoption or
modification of laws or regulations relating to commerce over
the Internet could substantially impair the growth of our
business or expose us to unanticipated liabilities. Moreover,
the applicability of existing laws to the Internet and hosting
and managed application service providers is uncertain. These
existing laws could expose us to substantial liability if they
are found to be applicable to our business. For example, we
provide services over the Internet in many states in the United
States and elsewhere and facilitate the activities of our
customers in such jurisdictions. As a result, we may be required
to qualify to do business, be subject to taxation or be subject
to other laws and regulations in these jurisdictions, even if we
do not have a physical presence, employees or property in those
states.


The price of our common stock has been
volatile, and may continue to experience wide
fluctuations.Since
January 1, 2004, our common stock has closed as low as
$1.41 per share and as high as $7.30 per share. The
trading price of our common stock has been and may continue to
be subject to wide fluctuations due to the risk factors
discussed in this section and elsewhere in this report. Should
the market price of our common stock be below $1.00 per
share for an extended period, Nasdaq may delist our common
stock, which would have an adverse effect on the trading of our
common stock. On June 10, 2002, the listing of our common
stock transferred from the Nasdaq National Market to the Nasdaq
SmallCap Market because the market price of our common stock had
failed to maintain compliance with the Nasdaq National
Markets minimum $1.00 per share continued listing
requirement. A delisting of our common stock from Nasdaq could
materially reduce the liquidity of our common stock and result
in a corresponding material reduction in the price of our common
stock. In addition, any such delisting could harm our ability to
raise capital through alternative financing sources on terms
acceptable to us, or at all, and may result in the potential
loss of confidence by suppliers, customers and employees.

Anti-takeover provisions in our corporate
documents may discourage or prevent a
takeover.Provisions in our
certificate of incorporation and our by-laws may have the effect
of delaying or preventing an acquisition or merger in which we
are acquired or a transaction that changes our Board of
Directors. These provisions:



| |   |                                                                                                                                                                                       
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | authorize the board to issue preferred stock
    without stockholder approval;                                                                                                        
|
| |  | prohibit cumulative voting in the election of
    directors;                                                                                                                          
|
| |  | limit the persons who may call special meetings
    of stockholders; and                                                                                                              
|
| |  | establish advance notice requirements for
    nominations for the election of directors or for proposing
    matters that can be acted on by stockholders at stockholder
    meetings.






|        |           
|------- | ----------
|Item 2. | Properties

Facilities

Our executive offices are located at 400
Minuteman Road, Andover, Massachusetts. We lease offices and
data centers in various cities across the United States and have
an office and data center in the United Kingdom. The table below
sets forth a list of our leased offices and data centers:

|                  |  |                        |  |                |        |                  |  |  |                | 
|----------------- |  | ---------------------- |  | -------------- | ------ | ---------------- |  |  | -------------- | 
|                  |  |                        |  | Square Footage |        |                 
|                  |  |                        |  | Leased         |        |                 
|Location          |  | Type                   |  | (Approximate)  |        | Lease Expiration
|                  |  |                        |  |                |        |                 
|San Jose, CA(1)   |  | Data Center and Office |  |                | 66,350 |                  |  |  | November 2006  | 
|La Jolla, CA(1)   |  | Office                 |  |                | 16,810 |                  |  |  | December 2006  | 
|Los Angeles, CA   |  | Data Center            |  |                | 34,711 |                  |  |  | February 2009  | 
|San Francisco, CA |  | Data Center            |  |                | 23,342 |                  |  |  | November 2009  | 
|Atlanta, GA(1)    |  | Office                 |  |                | 10,577 |                  |  |  | September 2006 | 
|Atlanta, GA(1)    |  | Office                 |  |                | 21,670 |                  |  |  | May 2005       | 
|Chicago, IL(1)    |  | Office                 |  |                | 4,453  |                  |  |  | February 2008  | 
|Chicago, IL       |  | Data Center            |  |                | 6,800  |                  |  |  | January 2009   | 
|Oak Brook, IL     |  | Data Center            |  |                | 16,780 |                  |  |  | September 2009 | 

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|                              |  |                        |  |                |        |                  |  |  |               | 
|----------------------------- |  | ---------------------- |  | -------------- | ------ | ---------------- |  |  | ------------- | 
|                              |  |                        |  | Square Footage |        |                 
|                              |  |                        |  | Leased         |        |                 
|Location                      |  | Type                   |  | (Approximate)  |        | Lease Expiration
|                              |  |                        |  |                |        |                 
|Andover, MA                   |  | Office                 |  |                | 16,500 |                  |  |  | March 2006    | 
|Andover, MA                   |  | Data Center and Office |  |                | 90,000 |                  |  |  | January 2018  | 
|Boston, MA                    |  | Data Center and Office |  |                | 4,651  |                  |  |  | December 2005 | 
|Lexington, MA                 |  | Office                 |  |                | 21,056 |                  |  |  | April 2006    | 
|Syracuse, NY                  |  | Data Center            |  |                | 21,246 |                  |  |  | November 2008 | 
|Syracuse, NY(1)               |  | Office                 |  |                | 44,002 |                  |  |  | December 2007 | 
|Syracuse, NY(1)               |  | Office                 |  |                | 5,016  |                  |  |  | May 2009      | 
|New York, NY                  |  | Office                 |  |                | 1,500  |                  |  |  | March 2005    | 
|New York, NY                  |  | Data Center            |  |                | 33,286 |                  |  |  | May 2008      | 
|Las Vegas, NV                 |  | Data Center            |  |                | 28,560 |                  |  |  | February 2010 | 
|Dallas, TX                    |  | Data Center            |  |                | 27,370 |                  |  |  | January 2010  | 
|Houston, TX(1)                |  | Data Center and Office |  |                | 29,545 |                  |  |  | October 2008  | 
|Vienna, VA(1)                 |  | Office                 |  |                | 22,270 |                  |  |  | July 2005     | 
|Vienna, VA                    |  | Data Center and Office |  |                | 23,715 |                  |  |  | February 2010 | 
|Milwaukee, WI                 |  | Data Center            |  |                | 5,200  |                  |  |  | March 2010    | 
|London, England               |  | Data Center            |  |                | 4,022  |                  |  |  | March 2010    | 
|Amsterdam, The Netherlands(1) |  | Office                 |  |                | 3,017  |                  |  |  | January 2005  | 



---



|    |                                                
|--- | -----------------------------------------------
|(1) | We have impaired office space at this facility.

We believe that these offices and data centers
are adequate to meet our foreseeable requirements and that
suitable additional or substitute space will be available on
commercially reasonable terms, if needed.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

IPO Securities Litigation

On or about June 13, 2001, Stuart Werman and
Lynn McFarlane filed a lawsuit against us, BancBoston Robertson
Stephens, an underwriter of our initial public offering in
October 1999, Joel B. Rosen, our then chief executive officer,
and Kenneth W. Hale, our then chief financial officer. The suit
was filed in the United States District Court for the Southern
District of New York. The suit generally alleges that the
defendants violated federal securities laws by not disclosing
certain actions allegedly taken by Robertson Stephens in
connection with our initial public offering. The suit alleges
specifically that Robertson Stephens, in exchange for the
allocation to its customers of shares of our common stock sold
in our initial public offering, solicited and received from its
customers agreements to purchase additional shares of our
common stock in the aftermarket at pre-determined prices. The
suit seeks unspecified monetary damages and certification of a
plaintiff class consisting of all persons who acquired shares of
our common stock between October 22, 1999 and
December 6, 2000. Three other substantially similar
lawsuits were filed between June 15, 2001 and July 10,
2001 by Moses Mayer (filed June 15, 2001), Barry Feldman
(filed June 19, 2001), and Binh Nguyen (filed July 10,
2001). Robert E. Eisenberg, our president at the time of the
initial public offering in 1999, also was named as a defendant
in the Nguyen lawsuit.

On or about June 21, 2001, David Federico
filed in the United States District Court for the Southern
District of New York a lawsuit against us, Mr. Rosen,
Mr. Hale, Robertson Stephens and other underwriter
defendants including J.P. Morgan Chase, First Albany
Companies, Inc., Bank of America Securities, LLC, Bear
Stearns & Co., Inc., B.T. Alex. Brown, Inc., Chase
Securities, Inc., CIBC World Markets, Credit Suisse First Boston
Corp., Dain Rauscher, Inc., Deutsche Bank Securities, Inc., The
Goldman Sachs Group, Inc., J.P. Morgan & Co.,
J.P. Morgan Securities, Lehman Brothers, Inc., Merrill
Lynch, Pierce, Fenner & Smith, Inc., Morgan Stanley
Dean Witter & Co., Robert Fleming, Inc. and Salomon
Smith Barney, Inc. The suit generally alleges that the
defendants violated the anti-trust laws and the federal
securities laws by conspiring

23



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and agreeing to raise and increase the
compensation received by the underwriter defendants by requiring
those who received allocation of initial public offering stock
to agree to purchase shares of manipulated securities in the
after-market of the initial public offering at escalating price
levels designed to inflate the price of the manipulated stock,
thus artificially creating an appearance of demand and high
prices for that stock, and initial public offering stock in
general, leading to further stock offerings. The suit also
alleges that the defendants arranged for the underwriter
defendants to receive undisclosed and excessive brokerage
commissions and that, as a consequence, the underwriter
defendants successfully increased investor interest in the
manipulated initial public offering of securities and increased
the underwriter defendants individual and collective
underwritings, compensation, and revenue. The suit further
alleges that the defendants violated the federal securities laws
by issuing and selling securities pursuant to the initial public
offering without disclosing to investors that the underwriter
defendants in the offering, including the lead underwriters, had
solicited and received excessive and undisclosed commissions
from certain investors. The suit seeks unspecified monetary
damages and certification of a plaintiff class consisting of all
persons who acquired shares of our common stock between
October 22, 1999 and June 12, 2001.


Those five cases, along with lawsuits naming more
than 300 other issuers and over 50 investment banks which have
been sued in substantially similar lawsuits, have been assigned
to the Honorable Shira A. Scheindlin (the Court) for
all pretrial purposes (the IPO Securities
Litigation). On September 6, 2001, the Court entered
an order consolidating the five individual cases involving us
and designating Werman v. NaviSite, Inc., et al.,
Civil Action No. 01-CV-5374 as the lead case. A
consolidated, amended complaint was filed thereafter on
April 19, 2002 (the Class Action
Litigation) on behalf of plaintiffs Arvid Brandstrom and
Tony Tse against underwriter defendants Robertson Stephens (as
successor-in-interest to BancBoston), BancBoston,
J.P. Morgan (as successor-in-interest to
Hambrecht & Quist), Hambrecht & Quist and
First Albany and against us and Messrs. Rosen, Hale and
Eisenberg (collectively, the NaviSite Defendants).
Plaintiffs uniformly allege that all defendants, including the
NaviSite Defendants, violated the federal securities laws (i.e.,
Sections 11 and 15 of the Securities Act,
Sections 10(b) and 20(a) of the Exchange Act and
Rule 10b-5) by issuing and selling our common stock
pursuant to the October 22, 1999, initial public offering,
without disclosing to investors that some of the underwriters of
the offering, including the lead underwriters, had solicited and
received extensive and undisclosed agreements from certain
investors to purchase aftermarket shares at pre-arranged,
escalating prices and also to receive additional commissions
and/or other compensation from those investors. At this time,
plaintiffs have not specified the amount of damages they are
seeking in the Class Action Litigation.

Between July and September 2002, the parties to
the IPO Securities Litigation briefed motions to dismiss filed
by the underwriter defendants and the issuer defendants,
including NaviSite. On November 1, 2002, the Court held
oral argument on the motions to dismiss. The plaintiffs have
since agreed to dismiss the claims against Messrs. Rosen,
Hale and Eisenberg without prejudice, in return for their
agreement to toll any statute of limitations applicable to those
claims. By stipulation entered by the Court on November 18,
2002, Messrs. Rosen, Hale and Eisenberg were dismissed
without prejudice from the Class Action Litigation. On
February 19, 2003, an opinion and order was issued on
defendants motion to dismiss the IPO Securities
Litigation, essentially denying the motions to dismiss of all 55
underwriter defendants and of 185 of the 301 issuer defendants,
including NaviSite.

On June 30, 2003, our Board of Directors
considered and authorized us to negotiate a settlement of the
pending Class Action Litigation substantially consistent
with a memorandum of understanding negotiated among class
plaintiffs, the issuer defendants and the insurers for such
issuer defendants. Among other contingencies, any such
settlement would be subject to approval by the Court. Plaintiffs
filed on June 14, 2004, a motion for preliminary approval
of the Stipulation And Agreement Of Settlement With Defendant
Issuers And Individuals (the Preliminary Approval
Motion). As of August 13, 2004, the Preliminary
Approval Motion has been fully briefed but the Court has not
ruled upon or set a date for oral argument, if any, on the
Preliminary Approval Motion. If completed and then approved by
the Court, the settlement is expected to be covered by our
existing insurance policies and is not expected to have a
material effect on our business, financial condition, results of
operations or cash flows.

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We believe that the allegations against us are
without merit and, if the settlement is not finalized, we intend
to vigorously defend against the plaintiffs claims. Due to
the inherent uncertainty of litigation, we are not able to
predict the possible outcome of the suits and their ultimate
effect, if any, on our business, financial condition, results of
operations or cash flows.

Joseph Cloonan

On or about September 27, 2002, we received
a demand for a wage payment of $850,000 from our former
Procurement Director, Joseph Cloonan. We rejected the demand,
alleging that Mr. Cloonans claim is based, among
other things, on a potentially fraudulent contract.
Mr. Cloonan also claimed $40,300 for allegedly unpaid
accrued vacation and bonuses and that he may be statutorily
entitled to treble damages and legal fees. On October 11,
2002, NaviSite filed a civil complaint with the Massachusetts
Superior Court, Essex County, seeking a declaratory judgment and
asserting claims against Mr. Cloonan for civil fraud,
misrepresentation, unjust enrichment and breach of duty of
loyalty. Mr. Cloonan asserted counter claims against
NaviSite seeking the payments set forth in his September 2002
demand. The discovery phase of the case has concluded and the
parties may serve dispositive motions through December 2004. We
believe Mr. Cloonans allegations are without merit
and intend to vigorously defend them. Due to the inherent
uncertainty of litigation, we are not able to predict the
possible outcome of this matter and the effect, if any, on our
business, financial condition, results of operations or cash
flows.

Lighthouse International

On October 28, 2002, CBTM, one of our
subsidiaries, filed a complaint in United States District Court
for the Southern District of New York against Lighthouse
International, alleging six causes of action for copyright
infringement, breach of contract, account stated, unjust
enrichment, unfair competition, and misappropriation and/or
conversion. The total claimed damages are in the amount of
approximately $1.9 million. On or about January 16,
2003, Lighthouse filed and served its answer and counterclaimed
against CBTM claiming approximately $3.1 million in damages
and $5.0 million in punitive relief.

On June 17, 2003, the U.S. Bankruptcy
Court for the Southern District of New York heard oral argument
on Lighthouses Motion for an Order Compelling the Debtor
(AppliedTheory) to Assume or Reject an Agreement, filed in
response to CBTMs complaint, and the objections to
Lighthouses motion filed by CBTM and AppliedTheory.
Lighthouse made this motion on the basis that it never received
notice of CBTM assuming the AppliedTheory contract for the
LighthouseLink Web site. The Bankruptcy Court declined to grant
Lighthouses motion, and instead ordered that an
evidentiary hearing be conducted to determine whether Lighthouse
received appropriate notice of the proposed assignment of the
contract by AppliedTheory to CBTM. The Bankruptcy Court ordered
that the parties first conduct discovery, and upon completion of
discovery, the Bankruptcy Court would schedule an evidentiary
hearing on the issues of due process and notice.

As to the U.S. District Court matter, the
exchange of written discovery and the majority of depositions of
witnesses have been completed. On June 15, 2004, District
Court Judge Pauley determined that both parties could proceed
with their respective summary judgment motions. All motion
papers were to be submitted by September 20, 2004, with
oral argument scheduled for October 15, 2004.

On August 4, 2004, however, upon the
application of CBTM, Bankruptcy Court Judge Gerber preliminarily
enjoined Lighthouse from asserting claims or counterclaims
against CBTM relating to the Lighthouse contract or any assets
acquired by CBTM from AppliedTheory pursuant to the sale order,
except for the purpose and to the extent necessary to setoff
claims brought by CBTM against Lighthouse relating to the
Lighthouse contract. As a result, Lighthouse is limited to
seeking only those pre- and post- bankruptcy counterclaims that
may constitute as set-offs against the claims asserted by CBTM.
Subsequent to issuing the injunction order, Bankruptcy Judge
Gerber held several conferences urging the parties to submit
their dispute to court-ordered mediation. In conjunction with
the Bankruptcy Courts request, District Court Judge Pauley
ordered a stay of all remaining expert discovery and motion
procedures pending the participation and

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##### Table of Contents



completion of mediation as requested by
Bankruptcy Court Judge Gerber. The matter was then transferred
to mediation by order of the Courts.


In September, 2004, the parties selected Harvey
A. Stricken, Esq. as mediator to the dispute. On
October 6, 2004, the mediation was held with no particular
outcome. Mr. Stricken has asked for follow-up discussions
with the parties on an individual basis to determine whether
continued mediation is warranted.

Pursuant to an October 1, 2004 Order of
Judge Pauley, the parties are to advise the District Court of
any disposition of the bankruptcy proceedings. A telephone
status conference on December 3, 2004 will also be held by
Judge Pauley. The stay of expert discovery and motion procedures
shall continue until that date. Because of the uncertain outcome
of such mediation, we are unable to predict the possible outcome
of this matter, if any, on our business, financial condition,
results of operations or cash flows.

Avasta Earnout

On October 14, 2003, we received a letter
purportedly on behalf of the former stockholders of Avasta, Inc.
relating to the issuance of additional shares of common stock
pursuant to the earnout calculations pursuant to the Agreement
and Plan of Merger and Reorganization dated as of
January 29, 2003 among Avasta Acquisition Corp., Avasta and
NaviSite. On December 11, 2003, a demand for arbitration
before JAMS (formerly known as Judicial Arbitration and
Mediation Services) was filed by Convergence Associates, Inc.
(Convergence Associates) on behalf of substantially
all of the former shareholders of Avasta claiming among other
things breach of contract, tortious conduct, fraud and other
wrongful conduct. Damages sought included in excess of
782,790 shares of our common stock. On September 30,
2004, the arbitrator issued a decision with respect to the
demand for arbitration. The arbitrator found that we breached
our obligations under the Agreement and ordered us to issue to
the former Avasta shareholders, or their designee, an aggregate
of 321,880 shares of our common stock. In addition, the
arbitrator determined that, as the prevailing party, Convergence
Associates is entitled to recover from us its reasonable
attorneys fees, costs and disbursements. On
October 11, 2004, Convergence Associates submitted its
application for reasonable attorneys fees, costs and
disbursements in the range of approximately $750,957 to
$957,000. We filed an objection to Convergence Associates
proposed fees on October 25, 2004. Convergence Associates
has until November 2, 2004 to respond to our objection.
When the arbitrator makes the final award of fees, that order,
together with the decision issued on September 30, 2004,
will constitute the final, non-appealable award of the
arbitrator.

Engage Bankruptcy Trustee Claim

On September 9, 2004, Don Hoy, Craig R.
Jalbert and David St. Pierre, as trustees of and on behalf of
the Engage, Inc. creditor trust, filed suit against us in the
United States Bankruptcy Court in the District of Massachusetts.
The suit generally relates to a termination agreement, dated
March 7, 2002, we entered into with Engage, Inc. (a company
then affiliated with CMGI, Inc.), which terminated a services
agreement between us and Engage and required Engage to pay us
$3.6 million. Engage made three payments to us under the
termination agreement in the aggregate amount of
$3.4 million. On June 19, 2003, Engage and five of its
wholly-owned subsidiaries filed petitions for relief under
Chapter 11 of Title 11 of the United States Bankruptcy
Code. The suit generally alleges that Engage was insolvent at
the time that we entered into the termination agreement with
Engage and at the time Engage made the payments to us.
Specifically, the suit alleges that (i) the plaintiffs are
entitled to avoid and recover $1.0 million paid by Engage
to us in the year prior to June 19, 2003 as a preferential
transfer, (ii) the plaintiffs are entitled to avoid and
recover $3.4 million (which amount includes the
$1.0 million payment made prior to June 13, 2003) paid
by Engage to us as a fraudulent transfer, and (iii) our
acts and omissions relating to the termination agreement and the
payments made by Engage to us constitute unfair and deceptive
acts or practices in willful and knowing violation of Mass. Gen.
Laws ch. 93A. In addition to the foregoing amounts, the
plaintiffs are also seeking treble damages, attorneys fees
and costs under Mass. Gen. Laws ch. 93A. As this matter is
in the initial stage, we are not able to predict the possible
outcome of this matter and the effect, if any, on our business,
financial condition, results of operations or cash flows, except
that we believe we have certain meritorious defenses to the
claims asserted in the complaint which we intend to assert
vigorously.

26



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

On May 6, 2004, Atlantic Investors, LLC, our
majority stockholder, delivered to us an executed written
consent of stockholders approving (i) the issuance of
(a) 3,000,000 shares of our common stock to
Surebridge, Inc., and (b) the shares of our common stock
issuable upon conversion of the convertible promissory notes in
the aggregate principal amount of $39.3 million issued by
us to Surebridge, Inc. and (ii) the amendment of our
Amended and Restated 2003 Stock Incentive Plan to increase the
maximum number of shares of our common stock available for
issuance thereunder from 3,800,000 to 6,800,000 shares.
Under federal law governing the taking of stockholder action by
written consent, the written consent will be deemed effective
20 days after the mailing of an information statement to
stockholders of NaviSite pursuant to the requirements of
Rule 14c-2 of the Securities Exchange Act of 1934, as
amended. NaviSite has not yet mailed the information statement
to its stockholders, and the written consent, therefore, has not
yet become effective.




PART II






|        |                                                                                                                      
|------- | ---------------------------------------------------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity
    , Related Stockholder Matters and Issuer Purchases of Equity
    Securities

Price Range of Common Stock

Our common stock is currently traded on the
Nasdaq SmallCap Market under the symbol NAVI. Prior
to June 7, 2002, our common stock was traded on the Nasdaq
National Market. As of September 30, 2004, there were 225
holders of record of our common stock. Because brokers and other
institutions on behalf of stockholders hold many of such shares,
we are unable to estimate the total number of stockholders
represented by these record holders. The following table sets
forth for the periods indicated the high and low sales prices
for our common stock as reported on the Nasdaq SmallCap Market
and on The Nasdaq National Market, and is adjusted to give
effect to the January 7, 2003 one-for-fifteen reverse stock
split.

|                                     |                                               |      |   |       |  |  |   |      | 
|------------------------------------ | --------------------------------------------- | ---- | - | ----- |  |  | - | ---- | 
|                                     |                                               | High |   | Low  
|                                     |                                               |      |   |      
|Fiscal Year Ended July 31,
    2004: |                                               |      |   |       |  |  |   |     
|                                     | May 1, 2004 through July 31, 2004             |      | $ | 5.45  |  |  | $ | 1.78 | 
|                                     | February 1, 2004 through April 30, 2004       |      | $ | 8.00  |  |  | $ | 3.74 | 
|                                     | November 1, 2003 through January 31,
    2004 |      | $ | 10.48 |  |  | $ | 4.21 | 
|                                     | August 1, 2003 through October 31, 2003       |      | $ | 5.45  |  |  | $ | 2.31 | 
|Fiscal Year Ended July 31,
    2003: |                                               |      |   |       |  |  |   |     
|                                     | May 1, 2003 through July 31, 2003             |      | $ | 3.97  |  |  | $ | 1.26 | 
|                                     | February 1, 2003 through April 30, 2003       |      | $ | 1.86  |  |  | $ | 0.92 | 
|                                     | November 1, 2002 through January 31,
    2003 |      | $ | 4.50  |  |  | $ | 0.85 | 
|                                     | August 1, 2002 through October 31, 2002       |      | $ | 4.20  |  |  | $ | 1.50 | 

We believe that a number of factors may cause the
market price of our common stock to fluctuate significantly. See
Item 1. Business  Certain Risk
Factors That May Affect Future Results.

We have never paid cash dividends on our common
stock. We currently anticipate retaining all available earnings,
if any, to finance internal growth and product development.
Payment of dividends in the future will depend upon our
earnings, financial condition, anticipated cash needs and such
other factors as the directors may consider or deem appropriate
at the time. In addition, the terms of our Accounts Receivable
Financing Agreement dated May 27, 2003, as amended, with
Silicon Valley Bank restricts the payment of cash dividends on
our common stock.

We did not repurchase any shares of common stock
during fiscal 2004.

Information regarding our equity compensation
plans and the securities authorized for issuance thereunder is
set forth in Item 12 below.

27



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##### Table of Contents



Recent Sales of Unregistered
Securities

On May 19, 2004, Silicon Valley Bancshares
exercised an outstanding warrant for the purchase of shares of
our common stock on a net issuance basis. Pursuant to the terms
of the warrant, we issued an aggregate of 73,738 shares of
common stock to Silicon Valley Bancshares. The shares of common
stock were issued and sold to Silicon Valley Bancshares in
reliance on Section 4(2) of the Securities Act of 1933, as
amended, as a sale by NaviSite not involving a public offering.
No underwriters were involved in the issuance and sale of these
shares of common stock.

On June 10, 2004, we acquired substantially
all of the assets and liabilities of Surebridge. Pursuant to the
terms of the asset purchase agreement dated May 6, 2004, on
June 10, 2004, the date of the closing, we issued to
Surebridge (i) 3,000,000 shares of our common stock,
and (ii) two convertible promissory notes in the aggregate
principal amount of approximately $39.3 million. The
promissory notes that we issued to Surebridge accrue interest on
the unpaid balance at an annual rate of 10%, however no interest
accrues on any principal paid within nine months of the closing.
In the event that we realize net proceeds in excess of
$1.0 million from equity or debt financings or sales of
assets, we are obligated to use a significant portion of the
proceeds to make payments on the notes. The notes must be paid
in full no later than the second anniversary of the closing. The
outstanding principal of, and accrued interest on, the notes are
convertible into shares of our common stock at a conversion
price of $4.642 at the election of the holder:



| |                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (i) at any time following the first
    anniversary of the closing if the aggregate principal
    outstanding under the notes at such time is greater than or
    equal to $20.0 million;    
|
| | (ii) at any time following the 18-month
    anniversary of the closing if the aggregate principal
    outstanding under the notes at such time is greater than or
    equal to $10.0 million;
|
| | (iii) at any time following the second
    anniversary of the closing; and                                                                                                                   
|
| | (iv) at any time following an event of
    default thereunder.                                                                                                                               

The offers and sales of these shares and the
promissory notes were effected without registration in reliance
on Section 4(2) of the Securities Act of 1933, as amended,
and Regulation D promulgated thereunder, as a sale by
NaviSite not involving a public offering. No underwriters were
involved in the issuance and sale of these shares of common
stock or the promissory notes.

28



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##### Table of Contents








|        |                                         
|------- | ----------------------------------------
|Item 6. | Selected Consolidated Financial
    Data

The following selected consolidated financial
data 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 included elsewhere in
this report. Historical results are not necessarily indicative
of results of any future period.

|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |        |         |  
|-------------------------------------------------------------------------- | ------------------------------------------------------- | ------------------------------------------------------------------------------------------ | ------- | ------ | ------- | ---- | ------- | ------- | ------- | ---- | ------ | ------- | -------- | - | ------- | ------- | -------- | - | ------- | ------ | ------- | -
|                                                                           |                                                         |                                                                                           
|                                                                           |                                                         | Year Ended July 31,                                                                       
|                                                                           |                                                         |                                                                                           
|                                                                           |                                                         | 2004                                                                                       |         | 2003   |         | 2002 |         | 2001    |         | 2000
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |     
|                                                                           |                                                         |                                                                                           
|                                                                           |                                                         | (In thousands, except per share data)                                                     
|Revenue                                                                    |                                                         | $                                                                                          | 91,126  |        |         | $    | 75,281  |         |         | $    | 40,968 |         |          | $ | 66,358  |         |          | $ | 24,870  |       
|Revenue, related parties                                                   |                                                         |                                                                                            | 46      |        |         |      | 1,310   |         |         |      | 18,453 |         |          |   | 36,368  |         |          |   | 24,893  |       
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           | Total revenue                                           |                                                                                            |         | 91,172 |         |      |         | 76,591  |         |      |        | 59,421  |          |   |         | 102,726 |          |   |         | 49,763 |        
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|Cost of revenue                                                            |                                                         |                                                                                            | 68,379  |        |         |      | 70,781  |         |         |      | 67,000 |         |          |   | 127,155 |         |          |   | 68,496  |       
|Impairment, restructuring and other                                        |                                                         |                                                                                            | 917     |        |         |      |        |         |         |      | 68,317 |         |          |   | 1,930   |         |          |   |        |       
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           |                                                         | Total cost of revenue                                                                      |         |        | 69,296  |      |         |         | 70,781  |      |        |         | 135,317  |   |         |         | 129,085  |   |         |        | 68,496  |  
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           |                                                         | Gross profit (loss)                                                                        |         |        | 21,876  |      |         |         | 5,810   |      |        |         | (75,896  | ) |         |         | (26,359  | ) |         |        | (18,733 | )
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|Operating expenses:                                                        |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           | Product development                                     |                                                                                            |         | 1,075  |         |      |         | 950     |         |      |        | 5,281   |          |   |         | 14,072  |          |   |         | 5,197  |        
|                                                                           | Selling and marketing                                   |                                                                                            |         | 9,567  |         |      |         | 5,960   |         |      |        | 9,703   |          |   |         | 32,251  |          |   |         | 22,805 |        
|                                                                           | General and administrative                              |                                                                                            |         | 24,714 |         |      |         | 20,207  |         |      |        | 19,272  |          |   |         | 33,011  |          |   |         | 12,270 |        
|                                                                           | Impairment, restructuring and other                     |                                                                                            |         | 5,286  |         |      |         | 8,882   |         |      |        | (2,633  | )        |   |         | 8,011   |          |   |         |       |        
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           |                                                         | Total operating expenses                                                                   |         |        | 40,642  |      |         |         | 35,999  |      |        |         | 31,623   |   |         |         | 87,345   |   |         |        | 40,272  |  
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           |                                                         | Loss from operations                                                                       |         |        | (18,766 | )    |         |         | (30,189 | )    |        |         | (107,519 | ) |         |         | (113,704 | ) |         |        | (59,005 | )
|Other income (expense):                                                    |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           | Interest income                                         |                                                                                            |         | 126    |         |      |         | 851     |         |      |        | 1,060   |          |   |         | 2,753   |          |   |         | 2,027  |        
|                                                                           | Interest expense                                        |                                                                                            |         | (3,181 | )       |      |         | (43,403 | )       |      |        | (14,718 | )        |   |         | (8,042  | )        |   |         | (1,001 | )      
|                                                                           | Other income (expense), net                             |                                                                                            |         | 468    |         |      |         | (733    | )       |      |        | (516    | )        |   |         | 292     |          |   |         | 9      |        
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           |                                                         | Loss before income tax expense and cumulative
    effect of change in accounting principle |         |        | (21,353 | )    |         |         | (73,474 | )    |        |         | (121,693 | ) |         |         | (118,701 | ) |         |        | (57,970 | )
|                                                                           | Income tax expense                                      |                                                                                            |         | (1     | )       |      |         | (153    | )       |      |        |        |          |   |         |        |          |   |         |       |        
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           |                                                         | Loss before cumulative effect of change in
    accounting principle                        |         |        | (21,354 | )    |         |         | (73,627 | )    |        |         | (121,693 | ) |         |         | (118,701 | ) |         |        | (57,970 | )
|                                                                           | Cumulative effect of change in accounting
    principle |                                                                                            |         |       |         |      |         |        |         |      |        |        |          |   |         | (4,295  | )        |   |         |       |        
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           |                                                         | Net loss                                                                                   |         | $      | (21,354 | )    |         | $       | (73,627 | )    |        | $       | (121,693 | ) |         | $       | (122,996 | ) |         | $      | (57,970 | )
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|Per common share:                                                          |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           | Basic and diluted:                                      |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |        |        
|                                                                           |                                                         | Loss before cumulative effect of change in
    accounting principle                        |         | $      | (0.85   | )    |         | $       | (6.32   | )    |        | $       | (22.30   | ) |         | $       | (30.18   | ) |         | $      | (20.57  | )
|                                                                           |                                                         | Cumulative effect of change in accounting
    principle                                    |         |        |        |      |         |         |        |      |        |         |         |   |         |         | (1.09    | ) |         |        |        |  
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|                                                                           |                                                         | Net loss                                                                                   |         | $      | (0.85   | )    |         | $       | (6.32   | )    |        | $       | (22.30   | ) |         | $       | (31.27   | ) |         | $      | (20.57  | )
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|Basic and diluted weighted average number of
    common shares outstanding |                                                         |                                                                                            | 25,160  |        |         |      | 11,654  |         |         |      | 5,457  |         |          |   | 3,933   |         |          |   | 2,818   |       
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|BALANCE SHEET DATA:                                                        |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|Working capital (deficit)                                                  |                                                         | $                                                                                          | (36,711 | )      |         | $    | (16,301 | )       |         | $    | 16,516 |         |          | $ | (9,683  | )       |          | $ | 48,159  |       
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|Total assets                                                               |                                                         | $                                                                                          | 123,864 |        |         | $    | 69,371  |         |         | $    | 53,534 |         |          | $ | 112,266 |         |          | $ | 175,461 |       
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|Long-term obligations                                                      |                                                         | $                                                                                          | 50,224  |        |         | $    | 13,577  |         |         | $    | 28,073 |         |          | $ | 69,852  |         |          | $ | 24,988  |       
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       
|Stockholders equity (deficit)                                             |                                                         | $                                                                                          | 11,082  |        |         | $    | 16,879  |         |         | $    | 8,544  |         |          | $ | (6,962  | )       |          | $ | 97,474  |       
|                                                                           |                                                         |                                                                                            |         |        |         |      |         |         |         |      |        |         |          |   |         |         |          |   |         |       

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|        |                                                                                           
|------- | ------------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations.

This Form 10-K contains forward-looking
statements within the meaning of Section 21E of the
Securities Exchange Act of 1934, as amended, and
Section 27A of the Securities Act of 1933, as amended, that
involve risks and uncertainties. All statements other than
statements of historical information provided herein are
forward-looking statements and may contain information about
financial results, economic conditions, trends and known
uncertainties. Our actual results could differ materially from
those discussed in the forward-looking statements as a result of
a number of factors, which include those discussed in this
section and elsewhere in this report under the heading
Certain Risk Factors that May Affect Future Results
and the risks discussed in our other filings with the Securities
and Exchange Commission. Readers are cautioned not to place
undue reliance on these forward-looking statements, which
reflect managements analysis, judgment, belief or
expectation only as of the date hereof. We undertake no
obligation to publicly revise these forward-looking statements
to reflect events or circumstances that arise after the date
hereof.

Overview

We provide our services to customers typically
pursuant to agreements with a term of one to three years and
monthly payment installments. As a result, these agreements
provide us with a base of recurring revenue. Our revenue
increases by adding new customers or additional services to
existing customers. Our overall base of recurring revenue is
affected by new customers, renewals or terminations of
agreements with existing customers.

A large portion of the costs to operate our data
centers, such as rent, product development and general and
administrative expenses, does not depend strictly on the number
of customers or the amount of services we provide. As we add new
customers or new services to existing customers, we generally
incur limited additional expenses relating to
telecommunications, utilities, hardware and software costs, and
payroll expenses. We have substantial capacity to add customers
to our data centers. Our relatively fixed cost base, sufficient
capacity for expansion and limited incremental variable costs
provide us with the opportunity to grow profitably. However,
these same fixed costs present us with the risk that we may
incur losses if we are unable to generate sufficient revenue.

In recent years, we have grown through
acquisitions of new businesses and have restructured our
historical operations. Specifically, in December 2002, we
acquired ClearBlue Technologies Management, Inc. (a wholly-owned
subsidiary of our majority stockholder at the time of the
acquisition and therefore was accounted for as a common control
merger), adding application management and development
capabilities to our Managed Application Services; in February
2003, we acquired Avasta, adding capabilities to our Managed
Application Services; in April 2003, we acquired Conxion,
providing key services to our Managed Application Services and
Managed Infrastructure Services; in May 2003, we acquired assets
of Interliant, forming the core of our Managed Messaging
Services; and in August 2003 and April 2004, we acquired assets
of CBT (which was our majority stockholder at that time and
therefore was accounted for as a common control merger) related
to colocation, bandwidth, security and disaster recovery
services, enhancing our Managed Infrastructure Services. In June
2004, we acquired substantially all of the assets and
liabilities of Surebridge adding significant capabilities to our
Managed Application and Professional Services. Prior to
September 2002, substantially all of our services were managed
application services, and we have added managed infrastructure
and managed messaging services and increased managed
applications and professional services since that time. This
transformation in our business will result in our recent results
being more relevant to an understanding of our business than our
historical results. We also expect to make additional
acquisitions to take advantage of our available capacity, which
will have significant effects on our financial results in the
future.

Our acquisitions of CBTM and assets of CBT were
accounted for in a manner similar to a pooling-of-interest due
to common control ownership. The assets and the liabilities of
CBT, CBTM and NaviSite were combined at their historical amounts
beginning on September 11, 2002, the date on which CBT
obtained a majority ownership of NaviSite. Our acquisitions of
Avasta and Conxion and selected assets of Interliant were
accounted for using the purchase method of accounting and as
such, the results of operations and cash flows relating to these
acquisitions were included in our Consolidated Statement of
Operations and Consolidated

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Statement of Cash Flows from their respective
dates of acquisition of February 5, 2003, April 2,
2003 and May 16, 2003. Our acquisition of substantially all
of the assets and liabilities of Surebridge was accounted for
using the purchase method of accounting and the results of
operations and cash flows relating to this acquisition have been
included in our Consolidated Statement of Operations and
Consolidated Statement of Cash Flows from its acquisition date
of June 10, 2004.


The audit report on our fiscal year 2004
consolidated financial statements from KPMG LLP, our independent
auditors, contains KPMGs opinion that our recurring losses
from operations since inception and accumulated deficit, as well
as other factors, raise substantial doubt about our ability to
continue as a going concern. While we cannot assure you that we
will continue as a going concern, we believe that we have
developed and are implementing an operational plan that aligns
our cost structure with our projected revenue growth.

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Results of Operations

The following table sets forth the percentage
relationships of certain items from our Consolidated Statements
of Operations as a percentage of total revenue.

|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |       |      |  
|----------------------------------- | ----------------------------------- | ------------------------ | ----- | ----- | ---- | ---- | ----- | ----- | ---- | - | ------ | ----- | ---- | -
|                                    |                                     |                         
|                                    |                                     | Year Ended July 31,     
|                                    |                                     |                         
|                                    |                                     | 2004                     |       | 2003  |      | 2002
|                                    |                                     |                          |       |       |      |     
|Revenue                             |                                     |                          | 99.9  | %     |      |      | 98.3  | %     |      |   | 68.9   | %    
|Revenue, related parties            |                                     |                          | 0.1   | %     |      |      | 1.7   | %     |      |   | 31.1   | %    
|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |      
|                                    | Total revenue                       |                          |       | 100.0 | %    |      |       | 100.0 | %    |   |        | 100.0 | %   
|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |      
|Cost of revenue                     |                                     |                          | 75.0  | %     |      |      | 92.4  | %     |      |   | 112.8  | %    
|Impairment, restructuring and other |                                     |                          | 1.0   | %     |      |      | 0.0   | %     |      |   | 115.0  | %    
|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |      
|                                    | Total cost of revenue               |                          |       | 76.0  | %    |      |       | 92.4  | %    |   |        | 227.8 | %   
|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |      
|Gross profit (loss)                 |                                     |                          | 24.0  | %     |      |      | 7.6   | %     |      |   | (127.8 | )%   
|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |      
|Operating expenses:                 |                                     |                          |       |       |      |      |       |       |      |   |        |      
|                                    | Product development                 |                          |       | 1.2   | %    |      |       | 1.2   | %    |   |        | 8.9   | %   
|                                    | Selling and marketing               |                          |       | 10.5  | %    |      |       | 7.8   | %    |   |        | 16.3  | %   
|                                    | General and administrative          |                          |       | 27.1  | %    |      |       | 26.4  | %    |   |        | 32.4  | %   
|                                    | Impairment, restructuring and other |                          |       | 5.8   | %    |      |       | 11.6  | %    |   |        | (4.4  | )%  
|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |      
|                                    |                                     | Total operating expenses |       |       | 44.6 | %    |       |       | 47.0 | % |        |       | 53.2 | %
|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |      
|Loss from operations                |                                     |                          | (20.6 | )%    |      |      | (39.4 | )%    |      |   | (181.0 | )%   
|Other income (expense):             |                                     |                          |       |       |      |      |       |       |      |   |        |      
|                                    | Interest income                     |                          |       | 0.1   | %    |      |       | 1.1   | %    |   |        | 1.8   | %   
|                                    | Interest expense                    |                          |       | (3.4  | )%   |      |       | (56.7 | )%   |   |        | (24.8 | )%  
|                                    | Other income (expense), net         |                          |       | 0.5   | %    |      |       | (1.0  | )%   |   |        | (0.9  | )%  
|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |      
|Loss before income tax expense      |                                     |                          | (23.4 | )%    |      |      | (96.0 | )%    |      |   | (204.9 | )%   
|Income tax expense                  |                                     |                          | 0.0   | %     |      |      | (0.2  | )%    |      |   | 0.0    | %    
|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |      
|Net loss                            |                                     |                          | (23.4 | )%    |      |      | (96.2 | )%    |      |   | (204.9 | )%   
|                                    |                                     |                          |       |       |      |      |       |       |      |   |        |      



| |                                                
| | -----------------------------------------------
| | Comparison of the Years 2004, 2003 and
    2002

Revenue

We derive our revenue from outsourced managed
hosting, colocation and application services comprised of a
variety of service offerings, including providing related
professional and consulting services, to mid-sized enterprises,
divisions of large multi-national companies and government
agencies.

Total revenue for fiscal year 2004 increased 19%
to approximately $91.2 million from approximately
$76.6 million in fiscal year 2003. The overall growth in
revenue was mainly due to the full year impact of the revenue
resulting from our fiscal year 2003 acquisitions and revenue
resulting from our fiscal year 2004 acquisitions which combined
contributed approximately $33.8 million in revenue during
the year ended July 31, 2004. The increased revenue during
fiscal year 2004 was partially offset by net lost customer
revenue of approximately $19.6 million. Revenue from
related parties decreased 96% during the year ended
July 31, 2004 to approximately $46,000 from approximately
$1.3 million during the year ended July 31, 2003.

Total revenue for fiscal year 2003 increased 29%
to approximately $76.6 million from approximately
$59.4 million in fiscal year 2002. The overall growth in
revenue was mainly due to revenue resulting from an increased
number of customers gained pursuant to our acquisitions, which
contributed approximately $48.7 million in revenue during
fiscal year 2003, offset by net lost customer revenue of
approximately $31.5 million. Revenue from non-related
parties increased by 84% to approximately $75.3 million in
fiscal year

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2003 from approximately $41.0 million in
fiscal year 2002 but was offset by a decline in revenue from
related parties. Revenue from related parties decreased by 93%
to approximately $1.3 million in fiscal year 2003 from
approximately $18.5 million in 2002. Revenue from related
parties principally consisted of sales of services to CMGI and
its affiliates until September 2002 when CMGI sold its equity
and debt interests in us to CBT, and then this related party
revenue was recorded as revenue. The decrease in related party
revenue for fiscal year 2003 as compared to fiscal year 2002 was
primarily attributable to CMGIs affiliates terminating
their relationships with us upon the completion of their
contracts.


Included in fiscal year 2002 revenue is
approximately $2.9 million in non-recurring revenue from
early contract termination settlements, primarily from related
parties, including $2.4 million from the termination of a
web hosting agreement with Engage, Inc.

In fiscal year 2004, one unrelated customer
accounted for 12% of our revenue. In fiscal year 2003, one
unrelated customer accounted for 21% of our revenue and in
fiscal year 2002 one CMGI affiliate accounted for approximately
11% of our revenue.

Gross Profit (Loss)

Cost of revenue consists primarily of salaries
and benefits for operations personnel, bandwidth fees and
related Internet connectivity charges, equipment costs and
related depreciation and costs to run our data centers, such as
rent and utilities.

Gross profit of $21.9 million for the year
ended July 31, 2004 increased approximately
$16.1 million, or 277%, from a gross profit of
approximately $5.8 million for the year ended July 31,
2003. Gross profit for fiscal year 2004 represented 24% of total
revenue, as compared to 8% of total revenue for fiscal year
2003. Total cost of revenue decreased approximately 2% to
$69.3 million in fiscal year 2004 from approximately
$70.8 million in fiscal year 2003. The decrease in cost of
revenue of $1.5 million resulted primarily from cost
reductions relating to the integration of our acquisitions, the
scaling of our fixed infrastructure costs over a larger
revenue/customer base, and the reduction of depreciation expense
due to lower levels of capital equipment purchases, partially
offset by an increase in amortization of intangible assets
related to our fiscal 2003 and 2004 acquisitions. Included in
total cost of revenue for fiscal year 2004 are impairment and
restructuring charges totaling $917,000.

Gross profit of $5.8 million for the year
ended July 31, 2003 increased approximately
$81.7 million, from a gross loss of $75.9 million for
the year ended July 31, 2002. Total cost of revenue
decreased 48% to approximately $70.8 million in fiscal year
2003 from approximately $135.3 million in fiscal year 2002.
An impairment charge of $68.3 million is included in total
cost of revenue for fiscal year 2002. The increase in cost of
revenue, net of the impairment charge, of $3.8 million
resulted primarily from the addition of approximately
$14.2 million in cost of revenue from the acquisitions of
subsidiaries of CBT netted with a $10.4 million reduction
in our cost of revenue. The $10.4 million reduction in our
cost of revenue consisted primarily of reductions in
depreciation of $11.1 million, equipment lease and related
costs of $6.4 million due to restructuring that took place
in fiscal year 2002 partially offset by increases in labor costs
of $4.0 million, bandwidth costs of $1.6 million and
software licenses of $1.4 million related to acquisitions
made in fiscal year 2003.

Cost of Revenue  Impairment,
Restructuring and Other

Costs associated with impairment, restructuring
and other were $0.9 million in fiscal year 2004, and relate
to the abandonment of data center space at our Vienna, Virginia
facility.

In fiscal year 2002, we recorded a
$68.3 million impairment charge related to leased and owned
equipment and long-lived assets. The components of this charge
are as follows:



| |   |                                                                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | As a result of a physical inventory of our
    customer-dedicated equipment, we recorded an impairment charge
    of $1.5 million for obsolete equipment and for equipment no
    longer on hand and identified certain excess assets not in use.

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We modified the payment amounts and terms of
    operating leases with three equipment vendors such that the
    modified leases qualify as capital leases. One of the resulting
    capital leases is payable in 24 equal monthly payments of
    $38,000, starting in December 2001. The second capital lease has
    total payments of $2.6 million, of which $1.0 million
    was paid in the second quarter of fiscal year 2002 and
    $1.6 million was paid in fiscal year 2003. The third
    capital lease is payable in 28 monthly payments of $4,700
    for the first four months and $20,400 for the remaining
    24 months, starting in April 2002. The equipment under all
    resulting capital leases was capitalized at the fair market
    value of the equipment at the time of the modification,
    determined to be $1.1 million, which was lower than the
    present value of the future minimum lease payments based on our
    estimated incremental borrowing rate of 12%. Because the fair
    market value of the equipment was less than the consideration
    given, based on a third-party appraisal, we recorded an asset
    impairment charge of approximately $1.0 million. In
    addition, we returned some equipment held under operating leases
    with one of the above lessors and incurred and paid a breakage
    fee of $397,000.
|
| |  | We recorded a net $1.9 million charge
    representing the future estimated remaining minimum lease
    payments related to certain idle equipment held under various
    operating leases. The equipment had previously been rented to
    former customers under operating leases, and upon the loss of
    the customer, the equipment became idle. Based on our then
    forecasts, the equipment would not be utilized before the
    related operating leases expired and/ or the equipment became
    obsolete.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  | We evaluated the current and forecasted
    utilization of our purchased software licenses. As a result of
    this evaluation, during the second quarter of fiscal year 2002,
    we recorded a $365,000 impairment for software licenses that
    would not be utilized before the licenses expired and/or became
    obsolete.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|
| |  | We finalized agreements with various equipment
    lessors whereby we purchased equipment previously held under
    operating leases for approximately $42.0 million. The fair
    market value of the equipment at the time of purchase, based on
    third-party appraisal, was approximately $14.3 million. As
    the aggregate fair market value of the equipment, based on
    third-party appraisal, was less than the aggregate consideration
    given, we recorded an asset impairment charge of approximately
    $24.9 million, as a separate component of cost of revenue,
    in fiscal year 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|
| |  | A number of factors occurring during the fourth
    quarter of fiscal year 2002 impacted our long-lived assets
    including both our expected future cash flow generation and our
    expected utilization of the assets within revised operating
    plans. These factors included the further deterioration of
    market conditions within our industry, excess capacity in the
    industry and in our two data centers, our anticipated data
    center utilization and our revised business model.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

Based on these factors and their impact on
current and future projected cash flows, we performed an
assessment of the carrying value of our long-lived assets
pursuant to Statement of Financial Accounting Standards
(SFAS) No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of. The conclusion of this assessment was that
the decline in market conditions within our industry was
significant and other than temporary. In this assessment, we
reviewed our long-lived assets, which included property,
equipment and goodwill. The carrying amount of goodwill, which
totaled $186,000, was considered unrecoverable and was
written-off as of July 31, 2002 and was included as a
component of general and administrative expense.

In accordance with SFAS No. 121, the
measurement of the impairment loss of property and equipment was
based on the fair value of the asset, as determined by
third-party appraisal. Management determined that the best
measure of fair value for the property and equipment was a
combination of the market and cost approaches. The cost approach
was utilized to determine the fair value of certain computer
hardware, leasehold improvements, office furniture and equipment
and construction in progress. The cost approach utilizes
estimated replacement/reproduction cost, with allowances for
physical depreciation and functional obsolescence (i.e. asset
utilization). For certain equipment and leasehold improvements,
the market approach was used. The market approach typically
includes comparing recent sales of similar assets and adjusting
these comparable transactions based on factors such as age,
condition, and type of sale to determine fair value.

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Based on the appraised fair value of the property
and equipment, we recorded an impairment charge of approximately
$38.1 million during the fourth quarter of fiscal year 2002.


Operating Expenses

Product Development.Product development expense consists primarily of salaries and
related costs.

Product development expense increased 13% to
approximately $1.1 million in fiscal year 2004 from
approximately $950,000, in fiscal year 2003 and represented
approximately 1.2% of total revenue in both fiscal years. The
increase in product development expense of approximately
$125,000 is primarily related to increased salary expense
resulting from an increased headcount.

Product development expense decreased 82% to
approximately $950,000, or 1.2% of total revenue, in fiscal year
2003 from approximately $5.3 million, or 8.9% of total
revenue, in fiscal year 2002. The decrease in product
development expenses is primarily related to reduced headcount
and related costs resulting from the decrease in product
development personnel in fiscal year 2003 from fiscal year 2002,
combined with a reduction in allocated depreciation and
equipment rental expense.

Selling and
Marketing.Selling and marketing
expense consists primarily of salaries and related benefits,
commissions and marketing expenses such as advertising, product
literature, trade show, and marketing and direct mail programs.

Selling and marketing expense increased 61% to
approximately $9.6 million, or 10.5% of total revenue, in
fiscal year 2004 from approximately $6.0 million, or 7.8%
of total revenue, in fiscal year 2003. The increase of
approximately $3.6 million resulted primarily from
increased salary expense resulting from an increased headcount
of selling personnel as well as an increase in marketing program
costs.

Selling and marketing expense decreased 39% to
approximately $6.0 million, or 7.8% of total revenue, in
fiscal year 2003 from approximately $9.7 million, or 16.3%
of total revenue, in fiscal year 2002. The decrease of
approximately $3.7 million resulted primarily from a
reduction in salary and related costs of approximately
$2.6 million, a reduction of allocated rent of
approximately $800,000 and a reduction in marketing program
costs of approximately $300,000.

General and
Administrative.General and
administrative expense includes the costs of financial, human
resources, IT and administrative personnel, professional
services, bad debt and corporate overhead.

General and administrative expense increased 22%
to approximately $24.7 million, or 27.1% of total revenue,
in fiscal year 2004 from approximately $20.2 million, or
26.4% of total revenue, in fiscal year 2003. The increase of
approximately $4.5 million was primarily the result of
increased salary expense resulting from an increased headcount,
as well as increases in legal expenses and bad debt expense
partially offset by decreases in severance, consulting,
insurance and accounting fees.

General and administrative expense increased 4.9%
to approximately $20.2 million, or 26.4% of total revenue,
in fiscal year 2003 from approximately $19.3 million, or
32.4% of total revenue, in fiscal year 2002. The increase of
approximately $935,000 was mainly the result of the addition of
approximately $1.3 million in CBT general and
administrative expense, offset by a net decrease in expenses of
approximately $400,000. The $400,000 is primarily comprised of a
reduction in bad debt expense of $2.5 million, partially
offset by increases in headcount related expenses of
$1.2 million, increased accounting and legal fees of
$800,000 and increased expense for amortization of intangibles
related to the CBTM acquisition during the fiscal year.

Operating Expenses  Impairment,
Restructuring and Other

Costs associated with impairment, restructuring
and abandonment of leased facilities included in operating
expenses were approximately $5.3 million in fiscal year
2004, as compared to costs associated with impairment,
restructuring and abandonment of lease facilities of
approximately $8.9 million in fiscal year 2003. The costs
incurred during fiscal year 2004 relate primarily to the
abandonment of administrative space at our San Jose,
California; Houston, Texas; and Syracuse, New York facilities.

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Costs associated with impairment, restructuring
and other increased to approximately $8.9 million in fiscal
year 2003 compared to a reversal of a portion of a previous
impairment and restructuring charge of approximately
$2.6 million in fiscal year 2002. The increase is due
primarily to abandonment of administrative space at our 400
Minuteman Road, Andover, Massachusetts facility and the
abandonment of administrative space at our La Jolla,
California office and approximately $2.0 million impairment
of intangible assets by CBT. We recorded a charge equal to the
amount of rent and other direct costs for the period the space
is expected to remain unoccupied plus the present value of the
amount by which the rent paid by us to the landlord exceeds any
rent paid to us by a subtenant under a sublease over the
remainder of the lease term.

Interest Income

Interest income decreased 85% to approximately
$126,000, or 0.1% of total revenue, in fiscal year 2004 from
approximately $851,000, or 1.1% of total revenue, in fiscal year
2003. The decrease is due primarily to the reduced levels of
average cash on hand.

Interest income decreased 20% to approximately
$851,000, or 1.1% of total revenue, in fiscal year 2003 from
approximately $1.1 million, or 1.8% of total revenue, in
fiscal year 2002. The decrease is due primarily to the reduced
levels of average cash on hand.

Interest Expense

Interest expense decreased 93% to approximately
$3.2 million, or 3.4% of total revenue, in fiscal year 2004
from approximately $43.4 million, or 56.7% of total
revenue, in fiscal year 2003. The decrease of $40.2 million
is due mainly to the non-cash write-off of the unamortized
beneficial conversion feature related to the conversion of the
$65 million of convertible notes during fiscal year 2003.

Interest expense increased 195% to approximately
$43.4 million, or 56.7% of total revenue, in fiscal year
2003 from approximately $14.7 million, or 24.8% of total
revenue, in fiscal year 2002. The increase of $28.7 million
is due mainly to the non-cash write-off of the unamortized
beneficial conversion feature related to the conversion of the
$65.0 million of convertible notes during fiscal year 2003.

Other Income (Expense), Net

Other income was approximately $468,000 in fiscal
year 2004, as compared to other expense of approximately
$733,000 in fiscal year 2003. The other income recorded during
fiscal year 2004 includes a $350,000 settlement related to a
sublease agreement.

Other expense increased 42% to an expense of
approximately $733,000 in fiscal year 2003 from an expense of
$516,000 in fiscal year 2002. This increase is mainly due to
increased fees related to the accounts receivable financing
agreement with Silicon Valley Bank.

Liquidity and Capital Resources

As of July 31, 2004, our principal sources
of liquidity included cash and cash equivalents and our
financing agreement with Silicon Valley Bank. We had a working
capital deficit of $36.7 million, including cash and cash
equivalents of $3.2 million at July 31, 2004, as
compared to a working capital deficit of $16.3 million,
including cash and cash equivalents of $3.9 million, at
July 31, 2003.

The total net change in cash and cash equivalents
for the fiscal year ended July 31, 2004 was a decrease of
$0.7 million. The primary uses of cash during fiscal year
2004 included $4.6 million of cash used for operating
activities, $4.3 million for purchases of property and
equipment, and $8.0 million in repayments on notes payable
and capital lease obligations. Our primary sources of cash
during fiscal year 2004 were a $1.7 million decrease in
restricted cash, $0.4 million in proceeds associated with
the exercise of stock options under the employee stock option
plans, $13.5 million in net proceeds from our financing
agreements and $0.6 million in proceeds from sale-leaseback
and note payable transactions. Net cash used for operating
activities of $4.6 million during the fiscal year ended
July 31, 2004, resulted primarily from our
$21.4 million net loss, partially offset by
$22.6 million in non-cash charges, and $5.8 million
used by net changes in operating assets

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and liabilities. At July 31, 2004, we had an
accumulated deficit of $439.9 million, and have reported
losses from operations since incorporation. At July 31,
2003, we had an accumulated deficit of $415.7 million.


Prior to May 2003, our primary sources of cash to
fund our operations were sales of equity and convertible debt
securities. Since May 2003, our primary source of cash to fund
our operations and meet our contacted obligations and
commitments has been our accounts receivable financing agreement
with Silicon Valley Bank. On January 30, 2004, we amended
this agreement to, among other things, allow for future
borrowing to be based on monthly recurring revenue, increase the
maximum borrowings level from $10.0 million to
$12.8 million, and extend the term until January 29,
2006. On April 29, 2004, we amended this agreement, among
other things, to increase the maximum borrowing level from
$12.8 million to $20.4 million, and extend the term
until April 29, 2006. Under the amended agreement,
borrowings are based on monthly recurring revenue. We are
required to prepare and deliver a written request for an advance
of up to three times the value of total monthly recurring
revenue, calculated to be monthly revenue (including revenue
from New York State Department of Labor) less professional
services revenue. The bank may then provide an advance of 85% of
such value (or such other percentage as the bank may determine).
The interest rate under the agreement is variable and is
currently calculated at the banks published prime
rate plus four percent. Following completion of certain
equity or debt financings, and provided we continue to meet
certain ratios under the amended agreement, the interest rate
shall be reduced to the banks prime rate plus one percent.
In no event, however, will the prime rate be less than 4.25%.
Further, the amended agreement requires that we achieve EBITDA
of at least $1.00 on a quarterly basis. The agreement defines
EBITDA as earnings before interest, taxes, depreciation and
amortization in accordance with generally accepted accounting
principles and excluding acquisition-related costs and one-time
extraordinary charges. A default under the agreement could
result in, among other things, us not being able to borrow
additional amounts from Silicon Valley Bank and all or a portion
of our outstanding amounts may become due and payable on an
accelerated basis, which would adversely affect our liquidity
and our ability to manage our business. On July 31, 2004,
we had an outstanding balance under the amended agreement of
$20.4 million.

At July 31, 2004, the Company had
$1.8 million in outstanding standby letters of credit,
issued in connection with facility and equipment lease
agreements, which are 100% cash collateralized. Cash subject to
collateral requirements has been recorded as restricted cash and
is classified as non-current on our balance sheet at
July 31, 2004.

On June 10, 2004, in connection with our
acquisition of the Surebridge business, we issued two
convertible promissory notes in the aggregate principal amount
of approximately $39.3 million. Interest shall accrue on
the unpaid balance of the notes at the annual rate of 10%,
provided that if an event of default shall occur and be
continuing, the interest rate shall be 15%. Notwithstanding the
foregoing, no interest shall accrue or be payable on any
principal amounts repaid on or prior to the nine-month
anniversary of the issuance date of the notes. We must repay the
outstanding principal of the notes with all interest accrued
thereon, no later than June 10, 2006. In addition, if at
any time during the first six months after the date of issuance
of the notes we complete certain equity or debt financings,
including our proposed public offering, we are obligated to use
a significant portion of the proceeds to make payments on the
notes, depending on the total net proceeds received by us in the
financing. If we receive net proceeds of less than
$20.0 million in a debt or equity financing, then we would
be obligated to make a payment on the notes equal to 75% of the
net proceeds. If we receive net proceeds of between
$20.0 million and $30.0 million, then we would be
obligated to make a payment on the notes equal to
$15.0 million. If we receive net proceeds in excess of
$30.0 million, then we would be obligated to make a payment
on the notes equal to 50% of the net proceeds. Pursuant to the
terms of the acquisition agreement, $0.8 million of the
primary note is callable at any time for a period of one year
from June 10, 2004, the date of the Surebridge acquisition
closing. During the first quarter of fiscal year 2005, the
noteholder requested payment of $0.8 million and the
Company expects to pay this amount during the second quarter of
fiscal year 2005.

In addition, if we realize net proceeds in excess
of $1.0 million from certain equity or debt financings or
sales of assets at any time after six months from the date the
notes were issued, we are obligated to use a significant portion
of the proceeds to make payments on the notes, depending on the
total payments, if any, made on the notes during the first six
months after the notes were issued. If the amount we paid on the
notes

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during the first six months the notes were
outstanding is less than $10.0 million, we would be
obligated to make a payment on the notes equal to 75% of the net
proceeds. If the amount we paid on the notes during the first
six months the notes were outstanding was greater than
$15.0 million, we would be obligated to make a payment on
the notes equal to 50% of the net proceeds. If the amount we
paid on the notes during the first six months the notes were
outstanding is between $10.0 million and
$15.0 million, we would be obligated to make a payment on
the notes equal to a percentage between 50% and 75% of the net
proceeds received in the financing calculated in accordance with
a formula set forth in the notes.


It shall be deemed an event of default under the
notes if, among other things, we fail to pay when due any
amounts under the notes, if we fail to pay when due or
experience an event of default with respect to any debts having
an outstanding principal amount of $500,000 or more, if we are
delisted from the Nasdaq SmallCap Market, or if we are acquired
and the acquiring party does not expressly agree to assume the
notes. In addition, certain bankruptcy, reorganization,
insolvency, dissolution and receivership actions would be deemed
an event of default under the notes. If an event of default
under the notes occurs, the holder shall be entitled to declare
the notes immediately due and payable in full.

The notes provide that we shall not incur any
indebtedness in excess of $20.5 million in the aggregate,
unless such indebtedness is unsecured and expressly subordinated
to the notes, is otherwise permitted under the notes, or the
proceeds are used to make payments on the notes.

Finally, the outstanding principal of and accrued
interest on the notes are convertible into shares of NaviSite
common stock at a conversion price of $4.642 at the election of
the holder:



| |   |                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | at any time following the first anniversary of
    the closing if the aggregate principal outstanding under the
    notes at such time is greater than or equal to
    $20.0 million;   
|
| |  | at any time following the 18-month anniversary of
    the closing if the aggregate principal outstanding under the
    notes at such time is greater than or equal to
    $10.0 million;
|
| |  | at any time following the second anniversary of
    the closing; and                                                                                                                    
|
| |  | at any time following an event of default
    thereunder.                                                                                                                               

We anticipate that we will continue to incur net
losses in the future. We have taken several actions we believe
will allow us to continue as a going concern through
July 31, 2005, including the closing and integration of
strategic acquisitions, the changes to our senior management and
bringing costs more in line with projected revenue. We will need
to find sources of financing in order to remain a going concern.
Potential sources include our financing agreement with Silicon
Valley Bank and public or private sales of equity or debt
securities. We may also consider sales of assets to raise
additional cash. If we use a significant portion of the net
proceeds from an offering to acquire a company, technology or
product, we will need to raise additional debt or equity capital.

Our operating forecast incorporates material
trends, such as our acquisitions, reductions in workforce, loss
of related party revenue and closings of facilities. Our
forecast also incorporates the future cash flow benefits
expected from our continued efforts to increase efficiencies and
reduce redundancies. Nonetheless, our forecast includes the need
to raise additional funds. Our cash flow estimates are based
upon attaining certain levels of sales, maintaining budgeted
levels of operating expenses, collections of accounts receivable
and maintaining our current borrowing line with Silicon Valley
Bank among other assumptions, including the improvement in the
overall macroeconomic environment. However there can be no
assurance that we will be able to meet such assumptions. Our
sales estimate includes revenue from new and existing customers,
which may not be realized, and we may be required to further
reduce expenses if budgeted sales are not attained. We may be
unsuccessful in reducing expenses in proportion to any shortfall
in projected sales and our estimate of collections of accounts
receivable may be hindered by our customers ability to
pay. In addition, we are currently involved in various pending
and potential legal proceedings. While we believe that the
allegations against us in each of these matters are without
merit, and that we have a meritorious defense in each, we are
not able to predict the final outcomes of any of these matters
and the effect, if any, on our financial condition. If we are
ultimately unsuccessful in any of these matters, we could be
required to pay substantial amounts of cash and/or shares of our
common stock to the other parties. The amount and timing of any
such payments could adversely affect our financial condition.

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Contractual Obligations and Commercial
Commitments

We are obligated under various capital and
operating leases for facilities and equipment. Minimum annual
rental commitments under operating leases and other commitments
are as follows:

|                                   |  |                |         |           |  |           |        |           |  |         |        |  |  |   |        |  |  |   |        | 
|---------------------------------- |  | -------------- | ------- | --------- |  | --------- | ------ | --------- |  | ------- | ------ |  |  | - | ------ |  |  | - | ------ | 
|                                   |  |                |         | Less than |  |           |        |           |  | After  
|Description                        |  | Total          |         | 1 Year    |  | 1-3 Years |        | 4-5 Years |  | 5 Years
|                                   |  |                |         |           |  |           |        |           |  |        
|                                   |  |               
|                                   |  | (In thousands)
|Short/Long-term debt               |  | $              | 70,575  |           |  | $         | 24,951 |           |  | $       | 45,624 |  |  | $ |       |  |  | $ |       | 
|Interest on debt(a)                |  |                | 9,591   |           |  |           | 1,164  |           |  |         | 8,427  |  |  |   |       |  |  |   |       | 
|Capital leases                     |  |                | 3,551   |           |  |           | 1,845  |           |  |         | 1,706  |  |  |   |       |  |  |   |       | 
|Operating leases                   |  |                | 629     |           |  |           | 558    |           |  |         | 71     |  |  |   |       |  |  |   |       | 
|Minimum bandwidth commitments      |  |                | 7,821   |           |  |           | 3,781  |           |  |         | 3,836  |  |  |   | 204    |  |  |   |       | 
|Maintenance for hardware/ software |  |                | 1,051   |           |  |           | 731    |           |  |         | 320    |  |  |   |       |  |  |   |       | 
|Property leases(b)                 |  |                | 63,880  |           |  |           | 13,528 |           |  |         | 21,423 |  |  |   | 14,297 |  |  |   | 14,632 | 
|                                   |  |                |         |           |  |           |        |           |  |         |        |  |  |   |        |  |  |   |        | 
|                                   |  | $              | 157,098 |           |  | $         | 46,558 |           |  | $       | 81,407 |  |  | $ | 14,501 |  |  | $ | 14,632 | 
|                                   |  |                |         |           |  |           |        |           |  |         |        |  |  |   |        |  |  |   |        | 



---



|    |                                                                                                                                   
|--- | ----------------------------------------------------------------------------------------------------------------------------------
|(a) | Amounts do not include interest on the accounts
    receivable financing line, as interest rate is variable.                      
|   
|(b) | Amounts exclude certain common area maintenance
    and other property charges that are not included within the
    lease payment.

Critical Accounting Policies

We prepare our consolidated financial statements
in accordance with accounting principles generally accepted in
the United States of America. As such, management is required to
make certain estimates, judgments and assumptions that it
believes are reasonable based on the information available.
These estimates and assumptions affect the reported amounts of
assets and liabilities at the date of the financial statements
and the reported amounts of revenues and expenses for the
periods presented. The significant accounting policies which
management believes are the most critical to aid in fully
understanding and evaluating our reported financial results
include revenue recognition, allowance for doubtful accounts and
impairment of long-lived assets. Management reviews the
estimates on a regular basis and makes adjustments based on
historical experiences, current conditions and future
expectations. The reviews are performed regularly and
adjustments are made as required by current available
information. We believe these estimates are reasonable, but
actual results could differ from these estimates.

Revenue Recognition.Revenue consists of monthly fees for Web site and Internet
application management, hosting, colocations and professional
services. The Company also derives revenue from the sale of
software and related maintenance contracts. Reimbursable
expenses charged to clients are included in revenue and cost of
revenue. Application management, hosting and colocation revenue
(other than installation fees) is billed and recognized over the
term of the contract, generally one to three years, based on
actual usage. Payments received in advance of providing services
are deferred until the period such services are provided.
Revenue from professional services, application management,
hosting and colocation revenue is recognized on either a
time-and material basis as the services are performed or under
the percentage of completion method for fixed-price contracts.
We generally sell our professional services under contracts with
terms ranging from one to five years. When current contract
estimates indicate that a loss is probable, a provision is made
for the total anticipated loss in the current period. Contract
losses are determined to be the amount by which the estimated
service costs of the contract exceed the estimated revenue that
will be generated by the contract. Unbilled accounts receivable
represents revenue for services performed that have not been
billed. Billings in excess of revenue recognized are recorded as
deferred revenue until the applicable revenue recognition
criteria are met. Revenue from the sale of software is
recognized when persuasive evidence of an arrangement exists,
the product has been delivered, the fees are fixed and
determinable and collection of the resulting receivable is
reasonably assured. In instances where the Company also provides
application management and hosting services in conjunction with
the sale of software, software revenue is deferred and
recognized ratably over the

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expected customer relationship period. If we
determine that collection of a fee is not reasonably assured, we
defer the fee and recognize revenue at the time collection
becomes reasonably assured, which is generally upon receipt of
cash.


Existing customers are subject to ongoing credit
evaluations based on payment history and other factors. If it is
determined subsequent to our initial evaluation and at any time
during the arrangement that collectability is not reasonably
assured, revenue is recognized as cash is received. Due to the
nature of our service arrangements, we provide written notice of
termination of services, typically 10 days in advance of
disconnecting a customer. Revenue for services rendered during
this notification period is generally recognized on a cash basis
as collectability is not considered probable at the time the
services are provided.

Allowance for Doubtful
Accounts.We perform periodic credit
evaluations of our customers financial conditions and
generally do not require collateral or other security against
trade receivables. We make estimates of the uncollectability of
our accounts receivables and maintain an allowance for doubtful
accounts for potential credit losses. We specifically analyze
accounts receivable and consider historical bad debts, customer
and industry concentrations, customer credit-worthiness, current
economic trends and changes in our customer payment patterns
when evaluating the adequacy of the allowance for doubtful
accounts. We specifically reserve for 100% of the balance of
customer accounts deemed uncollectible. For all other customer
accounts, we reserve for 20% of the balance over 90 days
old and 2% of all other customer balances. Changes in economic
conditions or the financial viability of our customers may
result in additional provisions for doubtful accounts in excess
of our current estimate.

Impairment of Long-lived
Assets.We review our long-lived
assets, subject to amortization and depreciation, including
customer lists and property and equipment, for impairment
whenever events or changes in circumstances indicate that the
carrying amount of these assets may not be recoverable. Factors
we consider important that could trigger an interim impairment
review include:



| |   |                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------
| |  | significant underperformance relative to expected
    historical or projected future operating results;         
|
| |  | significant changes in the manner of our use of
    the acquired assets or the strategy of our overall business;
|
| |  | significant negative industry or economic trends;                                                               
|
| |  | significant declines in our stock price for a
    sustained period; and                                         
|
| |  | our market capitalization relative to net book
    value.                                                       

Recoverability is measured by a comparison of the
carrying amount of an asset to future undiscounted cash flows
expected to be generated by the asset. If the assets were
considered to be impaired, the impairment to be recognized would
be measured by the amount by which the carrying value of the
assets exceeds their fair value. Fair value is determined based
on discounted cash flows or appraised values, depending on the
nature of the asset. Assets to be disposed of are valued at the
lower of the carrying amount or their fair value less disposal
costs. Property and equipment is primarily comprised of
leasehold improvements, computer and office equipment and
software licenses. Intangible assets consist of customer lists.

We review the valuation of our goodwill in the
fourth quarter of each fiscal year. If an event or circumstance
indicates that it is more likely than not an impairment loss has
been incurred, we review the valuation of Goodwill on an interim
basis. An impairment loss is recognized to the extent that the
carrying amount of goodwill exceeds its implied fair value.
Impairment losses are recognized in operations.

New Accounting Pronouncements

In November 2002, the Emerging Issues Task Force
(EITF) reached a consensus on EITF Issue 00-21,
Accounting for Revenue Arrangements with Multiple
Deliverables. EITF Issue 00-21 provides guidance on
how to determine when an arrangement that involves multiple
revenue-generating activities or deliverables should be divided
into separate units of accounting for revenue recognition
purposes, and if this division is required, how the arrangement
consideration should be allocated among the separate units of

40



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accounting. The guidance in the consensus is
effective for revenue arrangements entered into on or after
January 1, 2004. The adoption of EITF Issue 00-21 did
not have a material effect on the Companys financial
position or results of operations.


In January 2003, Financial Accounting Standards
Board (FASB) Interpretation No. (FIN)
46, Consolidation of Variable Interest Entities, was
issued. FIN 46 requires certain variable interest entities
(VIE) to be consolidated by the primary beneficiary
of the entity if the equity investors in the entity do not have
the characteristics of a controlling financial interest or do
not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support
from other parties. FIN 46 is effective for all new VIEs
created or acquired after January 31, 2003. During December
2003, the FASB issued a new revision to FIN 46
(FIN 46R).

Under the revised provisions, public entities are
required to apply the guidance if the entity has interests in
VIEs commonly referred to as special-purpose entities for the
periods ending after December 15, 2003. The adoption of
FIN 46 and 46R did not have a material effect on our
consolidated financial statements.

In May 2003, the FASB issued Statement of
Financial Accounting Standards (SFAS) No. 150,
Accounting For Certain Financial Instruments with
Characteristics of Both Liabilities and Equity, which
establishes standards for how an issuer of financial instruments
classifies and measures certain financial instruments with
characteristics of both liabilities and equity. It requires that
an issuer classify a financial instrument that is within its
scope as a liability (or an asset in some circumstances) if, at
inception, the monetary value of the obligation is based solely
or predominantly on a fixed monetary amount known at inception,
variations in something other than the fair value of the
issuers equity shares or variations inversely related to
changes in the fair value of the issuers equity shares.
This Statement is effective for financial instruments entered
into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning
after June 15, 2003. On November 7, 2003 the FASB
deferred the classification and measurement provisions of
SFAS No. 150 as they apply to certain mandatory
redeemable non-controlling interests. This deferral is expected
to remain in effect while these provisions are further evaluated
by the FASB. We have not entered into or modified any financial
instruments covered by this statement after May 31, 2003
and the application of this standard is not expected to have a
material impact on our financial position or results of
operations.

In December 2003, the Securities and Exchange
Commission (SEC) issued Staff Accounting Bulletin
No. (SAB) 104, Revenue Recognition,
which supersedes SAB 101, Revenue Recognition in
Financial Statements. SAB 104s primary purpose
is to rescind accounting guidance contained in SAB 101
related to multiple element revenue arrangements, superseded as
a result of the issuance of EITF 00-21, Accounting
for Revenue Arrangements with Multiple Deliverables. The
issuance of SAB 104 reflects the concepts contained in
EITF 00-21; the other revenue recognition concepts
contained in SAB 101 remain largely unchanged. The
application of SAB 104 did not have a material impact on
the Companys financial position or results of operations.






|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    About Market Risk

We do not enter into financial instruments for
trading purposes. We do not use derivative financial instruments
or derivative commodity instruments in our investment portfolio
or enter into hedging transactions. Our exposure to market risk
associated with risk-sensitive instruments entered into for
purposes other than trading purposes is not material to
NaviSite. We currently have no significant foreign operations
and therefore face no material foreign currency exchange rate
risk.






|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

Our consolidated Financial Statements and
Schedule and the Report of the Independent Accountants appear
beginning on page F-1 of this report and are incorporated herein
by reference.

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|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

None.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

Evaluation of Disclosure Controls and
Procedures.Based on managements
evaluation (with the participation of NaviSites principal
executive officer and principal financial officer) as of the end
of the period covered by this report, NaviSites principal
executive officer and principal financial officer have concluded
that NaviSites disclosure controls and procedures (as
defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended, (the Exchange
Act)) are effective to ensure that information required to
be disclosed by NaviSite in reports that it files or submits
under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in Securities and
Exchange Commission rules and forms.

Changes in Internal Control Over Financial
Reporting.There was no change in
NaviSites internal control over financial reporting during
the fourth fiscal quarter that has materially affected, or is
reasonably likely to materially affect, NaviSites internal
control over financial reporting.






|         |                  
|-------- | -----------------
|Item 9B. | Other Information

None.




PART III

Certain information required by Part III of
this Form 10-K is omitted because we will file a definitive
proxy statement pursuant to Regulation 14A (the Proxy
Statement) not later than 120 days after the end of
the fiscal year covered by this Form 10-K, and certain
information to be included therein is incorporated herein by
reference.






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

Incorporated by reference to the portions of the
Definitive Proxy Statement entitled Proposal
No. 1  Election of Directors,
Additional Information  Management,
Additional Information  Section 16(a)
Beneficial Ownership Reporting Compliance and
Additional Information  Audit Committee
Financial Expert.

Code of Ethics.NaviSite has adopted a Code of Business Conduct and Ethics that
applies to all directors, officers and employees of NaviSite,
including NaviSites principal executive officer, and its
senior financial officers (principal financial officer and
controller or principal accounting officer, or persons
performing similar functions). A copy of NaviSites Code of
Business Conduct and Ethics is filed with or incorporated by
reference in this report.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

Incorporated by reference to the portions of the
Proxy Statement entitled Additional
Information  Executive Compensation,
Additional Information  Director
Compensation, Additional Information 
Compensation Committee Report, Additional
Information  Stock Performance Graph, and
Additional Information  Employment Agreements
and Severance and Change of Control Arrangements. The
information specified in Item 402(k) and (l) of
Regulation S-K and set forth in our Proxy Statement is not
incorporated by reference.






|         |                                                                                                       
|-------- | ------------------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management and Related Stockholder
    Matters

Incorporated by reference to the portion of the
Proxy Statement entitled Security Ownership of Certain
Beneficial Owners and Management.

42



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In addition, we are a controlled
company as defined in the rules of the Nasdaq Stock Market
because more than 50% of our voting stock is held by Atlantic
Investors, LLC. Therefore, we are not subject to certain rules
of the Nasdaq Stock Market, including those rules that would
otherwise require us to have (i) a majority of independent
directors on the Board; (ii) a nominating committee
composed solely of independent directors; and
(iii) director nominees selected, or recommended for the
Boards selection, either by a majority of the independent
directors or a nominating committee composed solely of
independent directors.

Equity Compensation Plan Information as of
July 31, 2004

The following table sets forth certain
information regarding NaviSites equity compensation plans
as of July 31, 2004.

|                                                               |  |                         |           |                      |  |                               |      |  |  |  |           | 
|-------------------------------------------------------------- |  | ----------------------- | --------- | -------------------- |  | ----------------------------- | ---- |  |  |  | --------- | 
|                                                               |  |                         |           |                      |  | (c)                          
|                                                               |  | (a)                     |           | (b)                  |  | Number of Securities         
|                                                               |  | Number of Securities to |           | Weighted-average     |  | Available for Future Issuance
|                                                               |  | be Issued Upon Exercise |           | Exercise Price of    |  | Under Equity Compensation    
|                                                               |  | of Outstanding Options, |           | Outstanding Options, |  | Plans (excluding securities  
|Plan Category                                                  |  | Warrants and Rights     |           | Warrants and Rights  |  | reflected in column (a))     
|                                                               |  |                         |           |                      |  |                              
|Equity compensation plans approved by security
    holders     |  |                         | 3,730,713 |                      |  | $                             | 7.10 |  |  |  | 159,634   | 
|Equity compensation plans not approved by
    security holders |  |                         | 1,613,500 |                      |  | $                             | 4.20 |  |  |  | 1,386,500 | 
|                                                               |  |                         |           |                      |  |                               |      |  |  |  |           | 
|Total                                                          |  |                         | 5,344,213 |                      |  |                               |      |  |  |  | 1,546,134 | 
|                                                               |  |                         |           |                      |  |                               |      |  |  |  |           | 






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

Incorporated by reference to the portion of the
Proxy Statement entitled Additional
Information  Certain Relationships and Related
Transactions.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accounting Fees and
    Services

Incorporated by reference to the portion of the
Proxy Statement entitled Additional
Information  Independent Auditors Fees
and Additional Information  Audit Committee
Policy on Pre-Approval of Services of Independent Auditors.




PART V






|         |                                            
|-------- | -------------------------------------------
|Item 15. | Exhibits, Financial Statement
    Schedules

1. Financial Statements.

The financial statements listed in the Index to
Consolidated Financial Statements are filed as part of this
report.

2. Financial Statement Schedule.

Financial Statement Schedule II of NaviSite
and the corresponding Report of Independent Registered Public
Accounting Firm on Financial Statement Schedule are filed as
part of this report. All other financial statement schedules
have been omitted as they are either not required, not
applicable, or the information is otherwise included.

3. Exhibits.

The Exhibits listed in the Exhibit Index
immediately preceding such Exhibits are filed with or
incorporated by reference in this report.

43



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##### Table of Contents






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.



| |               
| | --------------
| | NAVISITE, INC.

November 2, 2004

| |     |                     
| | --- | --------------------
| | By: | /s/ ARTHUR P. BECKER

| |                        
| | -----------------------
| |                        
| | Arthur P. Becker       
| | Chief Executive Officer

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

|                                         |  |                                                                                    |  |                  |  | 
|---------------------------------------- |  | ---------------------------------------------------------------------------------- |  | ---------------- |  | 
|                                         |  |                                                                                    |  |                 
|Signatures                               |  | Title                                                                              |  | Date            
|                                         |  |                                                                                    |  |                 
|                                        
|/s/ ANDREW RUHANAndrew Ruhan             |  | Chairman of the Board                                                              |  | November 2, 2004
|                                        
|/s/ ARTHUR P. BECKERArthur P. Becker     |  | Chief Executive Officer, President and Director
    (Principal Executive Officer)  |  | November 2, 2004
|                                        
|/s/ JOHN J. GAVIN, JR.John J. Gavin, Jr. |  | Chief Financial Officer (Principal Financial and
    Principal Accounting Officer) |  | November 2, 2004
|                                        
|/s/ GABRIEL RUHANGabriel Ruhan           |  | Chief Operating Officer and Director                                               |  | November 2, 2004
|                                        
|/s/ JAMES H. DENNEDYJames H. Dennedy     |  | Director                                                                           |  | November 2, 2004
|                                        
|/s/ LARRY W. SCHWARTZLarry W. Schwartz   |  | Director                                                                           |  | November 2, 2004
|                                        
|/s/ THOMAS R. EVANSThomas R. Evans       |  | Director                                                                           |  | November 2, 2004

44



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##### Table of Contents



INDEX TO EXHIBITS

|            |   |                        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|----------- | - | ---------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |   | Description of Exhibit
|            |   |                       
|            | 2 | .1                     |  | Stock Purchase Agreement, dated as of
    December 31, 2002, by and between ClearBlue Technologies,
    Inc. and the Registrant, is incorporated herein by reference to
    Exhibits to the Registrants Current Report on
    Form 8-K dated December 31, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|            | 2 | .2                     |  | Agreement and Plan of Merger and Reorganization,
    dated as of January 29, 2003, among Avasta Acquisition
    Corp., Avasta, Inc. and the Registrant, is incorporated herein
    by reference to Exhibits to the Registrants Quarterly
    Report on Form 10-Q for the fiscal quarter ended
    January 31, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|            | 2 | .3                     |  | Agreement and Plan of Merger, dated as of
    March 26, 2003, by and between the Registrant and Conxion
    Corporation and Union Acquisition, Corp., a Delaware corporation
    and wholly-owned subsidiary of the Registrant, is incorporated
    herein by reference to Exhibits to the Registrants Current
    Report on Form 8-K dated April 2, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|            | 2 | .4                     |  | Sale Order pursuant to 11 U.S.C.
    Sections 105, 363, and 1146(c) and Bankruptcy
    Rules 2002, 6004 and 6006 approving (i) Asset Purchase
    Agreement, (ii) Sale of Substantially All of Debtors
    Assets Free and Clear of All Liens, Claims, Encumbrances and
    Interests, (iii) Waiver of Stay Provisions under Bankruptcy
    Rule Section 6004 and 6006 and (iv) Granting Related
    Relief entered by the Bankruptcy Court for the Southern District
    of New York (White Plains) on May 15, 2003; together with
    the Asset Purchase Agreement, dated as of May 15, 2003, by
    and among Interliant, Inc. and certain of its subsidiaries, and
    Intrepid Acquisition Corp., a Delaware corporation and
    wholly-owned subsidiary of the Registrant, annexed thereto, is
    incorporated herein by reference to Exhibits to the
    Registrants Current Report on Form 8-K dated
    May 16, 2003.
|            | 2 | .5                     |  | Stock and Asset Acquisition Agreement, dated as
    of August 8, 2003, by and between the Registrant and
    ClearBlue Technologies, Inc., is incorporated herein by
    reference to the Registrants Current Report on
    Form 8-K dated August 8, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|            | 2 | .6                     |  | Amendment to Stock and Asset Acquisition
    Agreement dated as of February 6, 2004 by and among the
    Registrant, ClearBlue Technologies, Inc., ClearBlue
    Technologies/ New York, Inc., ClearBlue Technologies/
    Santa Clara, Inc., ClearBlue Technologies/ Dallas, Inc. and
    ClearBlue Technologies/ San Francisco, Inc. is incorporated
    herein by reference to Exhibit 2.1 to the Registrants
    Current Report on Form 8-K dated February 6, 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|            | 2 | .7                     |  | Asset Purchase Agreement, dated as of May 6,
    2004, by and among the Registrant, Lexington Acquisition Corp.
    and Surebridge, Inc., is incorporated herein by reference to
    Exhibit 2.1 to the Registrants Current Report on
    Form 8-K dated May 6, 2004 (File No. 000-27597).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|            | 2 | .8                     |  | First Amendment to Asset Purchase Agreement,
    dated as of June 10, 2004, by and among the Registrant,
    Lexington Acquisition Corp. and Surebridge, Inc. is incorporated
    herein by reference to Exhibit 2.2 to the Registrants
    Current Report on Form 8-K dated June 10, 2004 (File
    No. 000-27597).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|            | 3 | .1                     |  | Amended and Restated Certificate of Incorporation
    is incorporated herein by reference to Exhibits to the
    Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended October 31, 1999.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|            | 3 | .2                     |  | Certificate of Amendment of Amended and Restated
    Certificate of Incorporation, dated as of January 4, 2003,
    is incorporated herein by reference to Exhibits to the
    Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended January 31, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|            | 3 | .3                     |  | Certificate of Amendment of Amended and Restated
    Certificate of Incorporation, dated as of January 7, 2003,
    is incorporated herein by reference to Exhibits to the
    Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended January 31, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|            | 3 | .4                     |  | Amended and Restated By-Laws is incorporated
    herein by reference to Exhibits to the Registrants
    Quarterly Report on Form 10-Q for the fiscal quarter ended
    October 31, 1999.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|            | 4 | .1                     |  | Specimen certificate representing shares of
    common stock is incorporated herein by reference to Exhibits to
    the Registrants Registration Statement on Form S-1/A
    (File No. 333-83501).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

45



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|            |    |                        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|----------- | -- | ---------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |    | Description of Exhibit
|            |    |                       
|            | 10 | .1                     |  | Lease, dated as of May 14, 1999, by and
    between 400 River Limited Partnership and the Registrant is
    incorporated herein by reference to Exhibits to the
    Registrants Registration Statement on Form S-1 (File
    No. 333-83501).                                                                                                                                                                                                      
|            | 10 | .2                     |  | Amendment No. 1 to Lease, by and between 400
    River Limited Partnership and the Registrant is incorporated by
    reference to Exhibits to the Registrants Quarterly Report
    on Form 10-Q for the fiscal quarter ended October 31,
    2003.                                                                                                                                                                                                
|            | 10 | .3                     |  | Amendment No. 2 to Lease, dated
    December 1, 2003, by and between 400 River Limited
    Partnership and the Registrant is incorporated herein by
    reference to Exhibits to the Registrants Registration
    Statement on Form S-2 filed January 22, 2004 (File
    No. 333-112087).                                                                                                                                                         
|            | 10 | .4                     |  | Lease, made as of April 30, 1999, by and
    between CarrAmerica Realty Corporation and the Registrant is
    incorporated herein by reference to Exhibits to the
    Registrants Registration Statement on Form S-1 (File
    No. 333-83501).                                                                                                                                                                                                    
|            | 10 | .5(*)                  |  | Amended and Restated 1998 Equity Incentive Plan
    is incorporated herein by reference to Exhibits to the
    Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended October 31, 1999.                                                                                                                                                                                                                                       
|            | 10 | .6(*)                  |  | 1999 Employee Stock Purchase Plan is incorporated
    herein by reference to Exhibits to the Registrants
    Quarterly Report on Form 10-Q for the fiscal quarter ended
    October 31, 1999.                                                                                                                                                                                                                                                     
|            | 10 | .7(*)                  |  | 1999 Stock Option Plan for Non-Employee Directors
    is incorporated herein by reference to Exhibits to the
    Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended October 31, 1999.                                                                                                                                                                                                                                     
|            | 10 | .8                     |  | Tax Allocation Agreement, dated as of
    October 27, 1999, between CMGI, Inc. and the Registrant is
    incorporated herein by reference to Exhibits to the
    Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended October 31, 1999.                                                                                                                                                                                     
|            | 10 | .9                     |  | Irrevocable Standby Letter of Credit, dated as of
    December 3, 1999, between BankBoston, N.A. and the
    Registrant is incorporated herein by reference to Exhibits to
    the Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended January 31, 2000.                                                                                                                                                                   
|            | 10 | .10                    |  | Security Agreement and Assignment of Account,
    dated December 3, 1999, between BankBoston, N.A. and the
    Registrant is incorporated herein by reference to Exhibits to
    the Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended January 31, 2000.                                                                                                                                                                 
|            | 10 | .11                    |  | Letter Agreement, dated October 10, 2002,
    between ClearBlue Technologies, Inc. and the Registrant, is
    incorporated herein by reference to Exhibits to the
    Registrants Annual Report on Form 10-K for the fiscal
    year ended July 31, 2002.                                                                                                                                                                                         
|            | 10 | .12(*)                 |  | 2000 Stock Option Plan is incorporated herein by
    reference to Exhibits to the Registrants Annual Report on
    Form 10-K/A for the fiscal year ended July 31, 2002.                                                                                                                                                                                                                                                                           
|            | 10 | .13                    |  | Assignment Agreement dated October 11, 2002
    by and between the Registrant and Fir Tree Recovery Master Fund,
    LP and Fir Tree Value Partners, LDC is incorporated herein by
    reference to Exhibit 4 to the Schedule 13D filed by
    NaviSite on November 12, 2002 (File No. 005-56549).                                                                                                                                                 
|            | 10 | .14                    |  | Renunciation Letter dated October 11, 2002
    from the Registrant to Interliant, Inc. is incorporated by
    reference to Exhibit 4 to the Schedule 13D filed by
    NaviSite on November 12, 2002 (File No. 005-56549).                                                                                                                                                                                                                          
|            | 10 | .15                    |  | Sublease, dated as of December 20, 2002, by
    and between NaviPath, Inc. and the Registrant, is incorporated
    herein by reference to Exhibits to the Registrants
    Quarterly Report on Form 10-Q for the fiscal quarter ended
    January 31, 2003.                                                                                                                                                                                        
|            | 10 | .16                    |  | Statement of Work, dated as of January 1,
    2003, describing the services to be provided to ClearBlue
    Technologies, Inc. by the Registrant under the Outsourcing
    Agreement, dated as of January 1, 2003, by and between
    ClearBlue Technologies, Inc. and the Registrant, is incorporated
    herein by reference to Exhibits to the Registrants
    Quarterly Report of Form 10-Q for the fiscal quarter ended
    January 31, 2003.
|            | 10 | .17                    |  | Loan and Security Agreement, dated as of
    January 3, 2003, by and between ClearBlue Technologies,
    Inc. as Lender and the Registrant as Borrower, is incorporated
    herein by reference to Exhibits to the Registrants
    Quarterly Report of Form 10-Q for the fiscal quarter ended
    January 31, 2003.                                                                                                                               

46



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|            |    |                        |  |                                                                                                                                                                                                                                                                                                                                                                                                    
|----------- | -- | ---------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |    | Description of Exhibit
|            |    |                       
|            | 10 | .18                    |  | Loan and Security Agreement, dated as of
    January 3, 2003, by and between ClearBlue Technologies,
    Inc. as Borrower and the Registrant as Lender, is incorporated
    herein by reference to Exhibits to the Registrants
    Quarterly Report of Form 10-Q for the fiscal quarter ended
    January 31, 2003.                                                                               
|            | 10 | .19                    |  | Loan and Security Agreement, dated as of
    January 29, 2003, by and between Atlantic Investors, LLC as
    Lender and the Registrant as Borrower, is incorporated herein by
    reference to Exhibits to the Registrants Quarterly Report
    of Form 10-Q for the fiscal quarter ended January 31,
    2003.                                                                                   
|            | 10 | .20(*)                 |  | Employment Agreement, dated as of
    February 21, 2003, by and between Arthur Becker and the
    Registrant, is incorporated herein by reference to Exhibits to
    the Registrants Quarterly Report of Form 10-Q for the
    fiscal quarter ended January 31, 2003.                                                                                                                             
|            | 10 | .21(*)                 |  | Offer of Employment Letter to Jim Pluntze dated
    March 25, 2003, is incorporated herein by reference to
    Exhibits to the Registrants Quarterly Report on
    Form 10-Q for the fiscal quarter ended April 30, 2003.                                                                                                                                                                         
|            | 10 | .22(*)                 |  | Agreement, dated as of April 4, 2003, by and
    between the Registrant and James Pluntze, is incorporated herein
    by reference to Exhibits to the Registrants Quarterly
    Report on Form 10-Q for the fiscal quarter ended
    April 30, 2003.                                                                                                                                              
|            | 10 | .23                    |  | Accounts Receivable Financing Agreement dated
    May 27, 2003 by and between Silicon Valley Bank and the
    Registrant, ClearBlue Technologies Management, Inc., Avasta,
    Inc., Conxion Corporation and Intrepid Acquisition Corp., is
    incorporated herein by reference to Exhibits to the
    Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended April 30, 2003.
|            | 10 | .24                    |  | First Loan Modification Agreement, dated as of
    January 30, 2004, by and among the Registrant, Silicon
    Valley Bank, ClearBlue Technologies Management, Inc., Avasta,
    Inc., Conxion Corporation and Intrepid Acquisition Corp. is
    incorporated herein by reference to Exhibit 10.1 to the
    Registrants Current Report on Form 8-K dated
    January 30, 2004.                    
|            | 10 | .25                    |  | Second Loan Modification Agreement, dated
    April 29, 2004, by and among the Registrant, Silicon Valley
    Bank, ClearBlue Technologies Management, Inc., Avasta, Inc.,
    Conxion Corporation and Intrepid Acquisition Corp. is
    incorporated herein by reference to Exhibit 10.1 to the
    Registrants Current Report on Form 8-K dated
    April 29, 2004 (File No. 000-27597).        
|            | 10 | .26                    |  | Registration Rights Agreement dated May 27,
    2003 by and between the Registrant and Silicon Valley Bank, is
    incorporated herein by reference to Exhibits to the
    Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended April 30, 2003.                                                                                                                             
|            | 10 | .27                    |  | Registration Rights Agreement, dated as of
    January 30, 2004, by and between Silicon Valley Bank and
    NaviSite, Inc. is incorporated herein by reference to
    Exhibit 10.2 to the Registrants Current Report on
    Form 8-K dated January 30, 2004.                                                                                                                                      
|            | 10 | .28                    |  | Warrant to Purchase Stock, dated January 30,
    2004, issued by NaviSite, Inc. to Silicon Valley Bank is
    incorporated herein by reference to Exhibit 10.3 to the
    Registrants Current Report on Form 8-K dated
    January 30, 2004.                                                                                                                                                      
|            | 10 | .29                    |  | Intellectual Property Security Agreement dated
    May 27, 2003 by and between the Registrant and Silicon
    Valley Bank, is incorporated herein by reference to Exhibits to
    the Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended April 30, 2003.                                                                                                                  
|            | 10 | .30                    |  | First Amendment to Loan and Security Agreement,
    dated June 2, 2003, by and between ClearBlue Technologies,
    Inc. and the Registrant, is incorporated herein by reference to
    Exhibits to the Registrants Quarterly Report on
    Form 10-Q for the fiscal quarter ended April 30, 2003.                                                                                                 
|            | 10 | .31                    |  | Letter Agreement, dated December 11, 2002,
    between ClearBlue Technologies, Inc. and the Registrant, is
    incorporated by reference to Exhibits to the Registrants
    Quarterly Report on Form 10-Q for the fiscal quarter ended
    October 31, 2002.                                                                                                                                      
|            | 10 | .32(*)                 |  | Offer of Employment Letter to Kenneth Drake dated
    July 15, 2003 is incorporated by reference to Exhibits to
    the Registrants Annual Report on Form 10-K for the
    fiscal year ended July 31, 2003.                                                                                                                                                                                       
|            | 10 | .33(*)                 |  | Amended and Restated 2003 Stock Incentive Plan,
    as amended, is incorporated herein by reference to
    Appendix II to the Registrants Preliminary
    Schedule 14C filed May 14, 2004 (File
    No. 000-27597).                                                                                                                                                                               

47



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|            |    |                        |  |                                                                                                                                                                                                                                                                                                                                                                                                         
|----------- | -- | ---------------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |    | Description of Exhibit
|            |    |                       
|            | 10 | .34(*)                 |  | Form of Indemnification Agreement, as executed by
    Messrs. Andrew Ruhan, Arthur P. Becker, Gabriel Ruhan,
    James H. Dennedy, Larry W. Schwartz, Thomas R. Evans, John J.
    Gavin, Jr., James W. Pluntze and Kenneth Drake is
    incorporated by reference to Exhibits to the Registrants
    Annual Report on Form 10-K for the fiscal year ended
    July 31, 2003.                          
|            | 10 | .35                    |  | Professional Services Agreement between the New
    York State Department of Labor and AppliedTheory Corporation
    dated November 2, 2000, is incorporated herein by reference
    to Exhibit 10.56 of AppliedTheorys Annual Report on
    Form 10-K for the fiscal year ended December 31, 2000
    (File No. 000-25759).                                                                           
|            | 10 | .36                    |  | Amendment No. 1 to Professional Services
    Agreement, dated as of May 2, 2001, by and between the New
    York State Department of Labor and AppliedTheory Corporation is
    incorporated by reference to Exhibits to the Registrants
    Registration Statement on Form S-2 filed on
    January 22, 2004 (File No. 333-112087).                                                                   
|            | 10 | .37                    |  | Amendment No. 2 to Professional Services
    Agreement, dated as of October 5, 2001, by and between the
    New York State Department of Labor and AppliedTheory Corporation
    is incorporated by reference to Exhibits to the
    Registrants Registration Statement on Form S-2 filed
    on January 22, 2004 (File No. 333-112087).                                                               
|            | 10 | .38                    |  | Amendment No. 3 to Professional Services
    Agreement, dated as of July 24, 2002, by and between the
    New York State Department of Labor and AppliedTheory Corporation
    is incorporated by reference to Exhibits to the
    Registrants Registration Statement on Form S-2 filed
    on January 22, 2004 (File No. 333-112087).                                                                 
|            | 10 | .39                    |  | Amendment No. 4 to Professional Services
    Agreement, dated as of November 12, 2002, by and between
    the New York State Department of Labor and ClearBlue
    Technologies Management, Inc. (as assignee of AppliedTheory
    Corporation) is incorporated by reference to Exhibits to the
    Registrants Registration Statement on Form S-2 filed
    on January 22, 2004 (File No. 333-112087).
|            | 10 | .40                    |  | Amendment No. 5 to Professional Services
    Agreement, dated as of March 25, 2003, by and between the
    New York State Department of Labor and ClearBlue Technologies
    Management, Inc. (as assignee of AppliedTheory Corporation) is
    incorporated by reference to Exhibits to the Registrants
    Registration Statement on Form S-2 filed on
    January 22, 2004 (File No. 333-112087).   
|            | 10 | .41                    |  | Amendment No. 6 to Professional Services
    Agreement, dated as of September 24, 2003, by and between
    the New York State Department of Labor and ClearBlue
    Technologies Management, Inc. (as assignee of AppliedTheory
    Corporation) is incorporated by reference to Exhibits to the
    Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended October 31, 2003.      
|            | 10 | .42                    |  | Amendment No. 7 to Professional Services
    Agreement, dated as of January 5, 2004, by and between the
    New York State Department of Labor and ClearBlue Technologies
    Management, Inc. (as assignee of AppliedTheory Corporation) is
    incorporated by reference to Exhibit 10.6 to the
    Registrants Quarterly Report on Form 10-Q for the
    fiscal quarter ended January 31, 2004.     
|            | 10 | .43                    |  | Negotiable Promissory Note dated December 1,
    2003 issued by the Registrant to U.S. Managers Realty, Inc.
    is incorporated by reference to Exhibits to the
    Registrants Registration Statement on Form S-2 filed
    on January 22, 2004 (File No. 333-112087).                                                                                                                               
|            | 10 | .44                    |  | Negotiable Promissory Note dated
    December 23, 2003 issued by the Registrant to
    U.S. Managers Realty, Inc. is incorporated by reference to
    Exhibits to the Registrants Registration Statement on
    Form S-2 filed on January 22, 2004 (File
    No. 333-112087).                                                                                                                          
|            | 10 | .45                    |  | Letter, dated as of January 16, 2004, from
    Atlantic Investors, LLC as Lender to the Registrant as Borrower.
    is incorporated by reference to Exhibits to the
    Registrants Registration Statement on Form S-2 filed
    on January 22, 2004 (File No. 333-112087).                                                                                                                            
|            | 10 | .46                    |  | Promissory Note dated June 13, 2002 issued
    by ClearBlue Technologies Management, Inc. to AppliedTheory
    Corporation is incorporated by reference to Exhibits to the
    Registrants Registration Statement on Form S-2 filed
    on January 22, 2004 (File No. 333-112087).                                                                                                                     
|            | 10 | .47                    |  | Promissory Note dated June 13, 2002 issued
    by ClearBlue Technologies Management, Inc. to AppliedTheory
    Corporation is incorporated by reference to Exhibits to the
    Registrants Registration Statement on Form S-2 filed
    on January 22, 2004 (File No. 333-112087).                                                                                                                     

48



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##### Table of Contents



|            |    |                        |  |                                                                                                                                                                                                                                                                      
|----------- | -- | ---------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |    | Description of Exhibit
|            |    |                       
|            | 10 | .48                    |  | Lease and Services Agreement by and between
    NaviSite Europe Limited and Global Switch (London) Limited is
    incorporated by reference to Exhibits to the Registrants
    Registration Statement on Form S-2/A filed on March 8,
    2004 (File No. 333-12087).
|            | 10 | .49                    |  | Registration Rights Agreement, dated
    June 10, 2004, by and between the Registrant and
    Surebridge, Inc. is incorporated herein by reference to
    Exhibit 10.1 to the Registrants Current Report on
    Form 8-K dated June 10, 2004 (File No. 000-27597).  
|            | 10 | .50                    |  | Primary Note, dated June 10, 2004, issued by
    the Registrant to Surebridge, Inc. is incorporated herein by
    reference to Exhibit 10.2 to the Registrants Current
    Report on Form 8-K dated June 10, 2004 (File
    No. 000-27597).                         
|            | 10 | .51                    |  | Escrow Note, dated June 10, 2004, issued by
    the Registrant to Surebridge, Inc. is incorporated herein by
    reference to Exhibit 10.3 to the Registrants Current
    Report on Form 8-K dated June 10, 2004 (File
    No. 000-27597).                          
|            | 10 | .52(*)                 |  | Employment Agreement, dated as of May 6,
    2004, by and between the Registrant and John J. Gavin, Jr.
    is incorporated by reference to Exhibits to the
    Registrants Registration Statement on Form S-2/A
    filed on June 29, 2004 (File No. 333-12087).   
|            | 10 | .53                    |  | Letter dated as of July 13, 2004, from
    Atlantic Investors, LLC as Lender to the Registrant as Borrower
    is incorporated herein by reference to Exhibit 99.2 to the
    Registrants Current Report on Form 8-K dated
    October 12, 2004.                    
|            | 10 | .54                    |  | Amendment No. 3 to Lease, by and between 400
    River Limited Partnership and the Registrant, is incorporated
    herein by reference to Exhibit 99.1 to the
    Registrants Current Report on Form 8-K dated
    September 21, 2004.                              
|            | 10 | .55                    |  | Letter, dated as of October 12, 2004, from
    Atlantic Investors, LLC as Lender to the Registrant as Borrower
    is incorporated herein by reference to Exhibit 99.1 to the
    Registrants Current Report on Form 8-K dated
    October 12, 2004.                
|            | 10 | .56                    |  | Letter Agreement dated April 29, 2004 by and
    among Silicon Valley Bank and the Registrant, ClearBlue
    Technologies Management, Inc., Avasta, Inc., Conxion Corporation
    and Intrepid Acquisition Corp.                                                     
|            | 10 | .57                    |  | Letter Agreement dated October 27, 2004 by
    and among Silicon Valley Bank and the Registrant, ClearBlue
    Technologies Management, Inc., Avasta, Inc., Conxion
    Corporation, Intrepid Acquisition Corp. and Lexington
    Acquisition Corp.                  
|            | 10 | .58                    |  | Joinder Agreement dated as of July 28, 2004
    by and between Silicon Valley Bank and the Registrant, ClearBlue
    Technologies Management, Inc., Avasta, Inc., Conxion Corporation
    Intrepid Acquisition Corp. and Lexington Acquisition Corp.                 
|            | 14 |                        |  | Code of Business Conduct and Ethics of the
    Registrant is incorporated by reference to Exhibits to the
    Registrants Annual Report on Form 10-K for the fiscal
    year ended July 31, 2003.                                                                   
|            | 21 |                        |  | Subsidiaries of the Registrant.                                                                                                                                                                                                                                      
|            | 23 |                        |  | Consent of KPMG LLP, Independent Registered
    Public Accounting Firm.                                                                                                                                                                                              
|            | 31 | .1                     |  | Certification of Chief Executive Officer pursuant
    to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                              
|            | 31 | .2                     |  | Certification of Chief Financial Officer pursuant
    to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                              
|            | 32 | .1                     |  | Certification of the Chief Executive Officer
    pursuant to 18 U.S.C. Section 1350, as Adopted
    Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                       
|            | 32 | .2                     |  | Certification of the Chief Financial Officer
    pursuant to 18 U.S.C. Section 1350, as Adopted
    Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                       



---



|    |                                                                                                                                       
|--- | --------------------------------------------------------------------------------------------------------------------------------------
|(*) | Management contract or compensatory plan or
    arrangement required to be filed as an Exhibit to this Annual
    Report on Form 10-K.

49



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##### Table of Contents






INDEX TO NAVISITE, INC. CONSOLIDATED FINANCIAL
STATEMENTS

|                                                                                                                               |  |      |      | 
|------------------------------------------------------------------------------------------------------------------------------ |  | ---- | ---- | 
|                                                                                                                               |  | Page
|                                                                                                                               |  |     
|Report of Independent
    Registered Public Accounting Firm                                                                    |  |      | F-2  | 
|Consolidated Balance Sheets
    as of July 31, 2004 and 2003.                                                                  |  |      | F-3  | 
|Consolidated Statements of
    Operations for the years ended July 31, 2004, 2003 and
    2002.                                |  |      | F-4  | 
|Consolidated Statements of
    Changes in Stockholders Equity (Deficit) for the years
    ended July 31, 2004, 2003 and 2002. |  |      | F-5  | 
|Consolidated Statements of
    Cash Flows for the years ended July 31, 2004, 2003 and
    2002                                 |  |      | F-6  | 
|Notes to Consolidated
    Financial Statements                                                                                 |  |      | F-8  | 
|Report of Independent
    Registered Public Accounting Firm on Financial Statement
    Schedule                                |  |      | F-43 | 
|Financial Statement
    Schedule II  Valuation and Qualifying
    Accounts                                                    |  |      | F-44 | 

F-1



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##### Table of Contents






REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

The Board of Directors and Stockholders

NaviSite, Inc. and Subsidiaries:


We have audited the accompanying consolidated
balance sheets of NaviSite, Inc. and Subsidiaries as of
July 31, 2004 and 2003, and the related consolidated
statements of operations, changes in stockholders equity
(deficit), and cash flows for each of the years in the
three-year period ended July 31, 2004. These financial
statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

In our opinion, the financial statements referred
to above present fairly, in all material respects, the financial
position of NaviSite, Inc. and Subsidiaries as of July 31,
2004 and 2003, and the results of their operations and their
cash flows for each of the years in the three-year period ended
July 31, 2004, in conformity with accounting principles
generally accepted in the United States of America.

The accompanying financial statements have been
prepared assuming that the Company will continue as a going
concern. As discussed in Note 3 to the financial
statements, the Company has incurred recurring losses from
operations since inception and has an accumulated deficit. These
factors, among others as discussed in Note 3 to the
financial statements, raise substantial doubt about the
Companys ability to continue as a going concern.
Managements plans in regard to these matters are also
described in Note 3. The financial statements do not
include any adjustments that might result from the outcome of
this uncertainty.

/s/ KPMG LLP

Boston, Massachusetts

November 1, 2004


F-2



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##### Table of Contents






NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

|                                                                                                                                      |                                                                                                                                |                                            |          |        |         |  |          |        |        | 
|------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------ | -------- | ------ | ------- |  | -------- | ------ | ------ | 
|                                                                                                                                      |                                                                                                                                |                                           
|                                                                                                                                      |                                                                                                                                | July 31,                                  
|                                                                                                                                      |                                                                                                                                |                                           
|                                                                                                                                      |                                                                                                                                | 2004                                       |          | 2003  
|                                                                                                                                      |                                                                                                                                |                                            |          |       
|                                                                                                                                      |                                                                                                                                |                                           
|                                                                                                                                      |                                                                                                                                | (In thousands,                            
|                                                                                                                                      |                                                                                                                                | except par value)                         
|ASSETS                                                                                                                                |                                                                                                                                |                                            |          |        |         |  |          |       
|Current assets:                                                                                                                       |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                      | Cash and cash equivalents                                                                                                      |                                            | $        | 3,195  |         |  | $        | 3,862  |       
|                                                                                                                                      | Accounts receivable, less allowance for doubtful
    accounts of $2,498 and $2,030 at July 31, 2004 and 2003,
    respectively |                                            |          | 16,584 |         |  |          | 14,741 |       
|                                                                                                                                      | Unbilled accounts receivable                                                                                                   |                                            |          | 1,854  |         |  |          | 58     |       
|                                                                                                                                      | Due from related party                                                                                                         |                                            |          | 101    |         |  |          |       |       
|                                                                                                                                      | Prepaid expenses and other current assets                                                                                      |                                            |          | 4,113  |         |  |          | 3,953  |       
|                                                                                                                                      |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                      |                                                                                                                                | Total current assets                       |          |        | 25,847  |  |          |        | 22,614 | 
|Property and equipment, net                                                                                                           |                                                                                                                                |                                            | 20,794   |        |         |  | 22,165   |       
|Customer lists, less accumulated amortization of
    $7,875 and $3,724 at July 31, 2004 and 2003, respectively                        |                                                                                                                                |                                            | 23,151   |        |         |  | 12,052   |       
|Goodwill                                                                                                                              |                                                                                                                                |                                            | 45,920   |        |         |  | 3,206    |       
|Other assets                                                                                                                          |                                                                                                                                |                                            | 6,316    |        |         |  | 6,280    |       
|Restricted cash                                                                                                                       |                                                                                                                                |                                            | 1,836    |        |         |  | 3,054    |       
|                                                                                                                                      |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                      |                                                                                                                                | Total assets                               |          | $      | 123,864 |  |          | $      | 69,371 | 
|                                                                                                                                      |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                     
|LIABILITIES AND STOCKHOLDERS
    EQUITY                                                                                              |                                                                                                                                |                                            |          |        |         |  |          |       
|Current liabilities:                                                                                                                  |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                      | Accounts receivable financing line, net                                                                                        |                                            | $        | 20,240 |         |  | $        | 6,358  |       
|                                                                                                                                      | Notes payable, current portion                                                                                                 |                                            |          | 1,551  |         |  |          | 1,211  |       
|                                                                                                                                      | Note payable to related party                                                                                                  |                                            |          | 3,000  |         |  |          | 3,000  |       
|                                                                                                                                      | Capital lease obligations, current portion                                                                                     |                                            |          | 2,921  |         |  |          | 3,268  |       
|                                                                                                                                      | Accounts payable                                                                                                               |                                            |          | 8,285  |         |  |          | 4,371  |       
|                                                                                                                                      | Accrued expenses                                                                                                               |                                            |          | 18,890 |         |  |          | 15,044 |       
|                                                                                                                                      | Accrued lease abandonment costs, current portion                                                                               |                                            |          | 4,269  |         |  |          | 2,536  |       
|                                                                                                                                      | Deferred revenue                                                                                                               |                                            |          | 2,670  |         |  |          | 2,736  |       
|                                                                                                                                      | Customer deposits                                                                                                              |                                            |          | 732    |         |  |          | 391    |       
|                                                                                                                                      |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                      |                                                                                                                                | Total current liabilities                  |          |        | 62,558  |  |          |        | 38,915 | 
|Capital lease obligations, less current portion                                                                                       |                                                                                                                                |                                            | 469      |        |         |  | 1,907    |       
|Accrued lease abandonment costs, less current
    portion                                                                             |                                                                                                                                |                                            | 2,782    |        |         |  | 3,476    |       
|Other long-term liabilities                                                                                                           |                                                                                                                                |                                            | 1,349    |        |         |  | 2,194    |       
|Note to the AppliedTheory Estate                                                                                                      |                                                                                                                                |                                            | 6,000    |        |         |  | 6,000    |       
|Note payable, less current portion                                                                                                    |                                                                                                                                |                                            | 1,157    |        |         |  |         |       
|Convertible notes payable to Surebridge                                                                                               |                                                                                                                                |                                            | 38,467   |        |         |  |         |       
|                                                                                                                                      |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                      |                                                                                                                                | Total liabilities                          |          |        | 112,782 |  |          |        | 52,492 | 
|                                                                                                                                      |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                     
|Commitments and contingencies (Note 12)                                                                                               |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                     
|Stockholders equity:                                                                                                                 |                                                                                                                                |                                            |          |        |         |  |          |       
|Preferred stock, $0.01 par value; Authorized
    5,000 shares; Issued and outstanding: no shares at
    July 31, 2004 and 2003        |                                                                                                                                |                                            |         |        |         |  |         |       
|Common stock, $0.01 par value; Authorized
    395,000 shares; Issued and outstanding: 27,924 and 23,412
    at July 31, 2004 and 2003 |                                                                                                                                |                                            | 279      |        |         |  | 235      |       
|Deferred compensation                                                                                                                 |                                                                                                                                |                                            | (1,514   | )      |         |  |         |       
|Accumulated other comprehensive income (loss)                                                                                         |                                                                                                                                |                                            | 15       |        |         |  | (16      | )     
|Additional paid-in capital                                                                                                            |                                                                                                                                |                                            | 452,156  |        |         |  | 432,399  |       
|Accumulated deficit                                                                                                                   |                                                                                                                                |                                            | (439,854 | )      |         |  | (415,739 | )     
|                                                                                                                                      |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                      |                                                                                                                                | Total stockholders equity                 |          |        | 11,082  |  |          |        | 16,879 | 
|                                                                                                                                      |                                                                                                                                |                                            |          |        |         |  |          |       
|                                                                                                                                      |                                                                                                                                | Total liabilities and stockholders equity |          | $      | 123,864 |  |          | $      | 69,371 | 
|                                                                                                                                      |                                                                                                                                |                                            |          |        |         |  |          |       

See accompanying notes to consolidated financial
statements.

F-3



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##### Table of Contents






NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |         |        | 
|-------------------------------------------------------------------------- | ----------------------------------- | ------------------------------------- | ------- | ------ | ------ | ---- | ------- | ------- | ------ | - | -------- | ------- | ------ | 
|                                                                           |                                     |                                      
|                                                                           |                                     | Years Ended July 31,                 
|                                                                           |                                     |                                      
|                                                                           |                                     | 2004                                  |         | 2003   |        | 2002
|                                                                           |                                     |                                       |         |        |        |     
|                                                                           |                                     |                                      
|                                                                           |                                     | (In thousands, except per share data)
|Revenue                                                                    |                                     | $                                     | 91,126  |        |        | $    | 75,281  |         |        | $ | 40,968   |        
|Revenue, related parties                                                   |                                     |                                       | 46      |        |        |      | 1,310   |         |        |   | 18,453   |        
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|                                                                           | Total revenue                       |                                       |         | 91,172 |        |      |         | 76,591  |        |   |          | 59,421  |       
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|Cost of revenue                                                            |                                     |                                       | 68,379  |        |        |      | 70,781  |         |        |   | 67,000   |        
|Impairment, restructuring and other                                        |                                     |                                       | 917     |        |        |      |        |         |        |   | 68,317   |        
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|                                                                           | Total cost of revenue               |                                       |         | 69,296 |        |      |         | 70,781  |        |   |          | 135,317 |       
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|Gross profit (loss)                                                        |                                     |                                       | 21,876  |        |        |      | 5,810   |         |        |   | (75,896  | )      
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|Operating expenses:                                                        |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|                                                                           | Product development                 |                                       |         | 1,075  |        |      |         | 950     |        |   |          | 5,281   |       
|                                                                           | Selling and marketing               |                                       |         | 9,567  |        |      |         | 5,960   |        |   |          | 9,703   |       
|                                                                           | General and administrative          |                                       |         | 24,714 |        |      |         | 20,207  |        |   |          | 19,272  |       
|                                                                           | Impairment, restructuring and other |                                       |         | 5,286  |        |      |         | 8,882   |        |   |          | (2,633  | )     
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|                                                                           |                                     | Total operating expenses              |         |        | 40,642 |      |         |         | 35,999 |   |          |         | 31,623 | 
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|Loss from operations                                                       |                                     |                                       | (18,766 | )      |        |      | (30,189 | )       |        |   | (107,519 | )      
|Other income (expense):                                                    |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|                                                                           | Interest income                     |                                       |         | 126    |        |      |         | 851     |        |   |          | 1,060   |       
|                                                                           | Interest expense                    |                                       |         | (3,181 | )      |      |         | (43,403 | )      |   |          | (14,718 | )     
|                                                                           | Other income (expense), net         |                                       |         | 468    |        |      |         | (733    | )      |   |          | (516    | )     
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|Loss before income tax expense                                             |                                     |                                       | (21,353 | )      |        |      | (73,474 | )       |        |   | (121,693 | )      
|Income tax expense                                                         |                                     |                                       | (1      | )      |        |      | (153    | )       |        |   |         |        
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|Net loss                                                                   |                                     | $                                     | (21,354 | )      |        | $    | (73,627 | )       |        | $ | (121,693 | )      
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|Basic and diluted net loss per common share                                |                                     | $                                     | (0.85   | )      |        | $    | (6.32   | )       |        | $ | (22.30   | )      
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        
|Basic and diluted weighted average number of
    common shares outstanding |                                     |                                       | 25,160  |        |        |      | 11,654  |         |        |   | 5,457    |        
|                                                                           |                                     |                                       |         |        |        |      |         |         |        |   |          |        

See accompanying notes to consolidated financial
statements.

F-4



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##### Table of Contents






NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN
STOCKHOLDERS EQUITY (DEFICIT)

|                                                                                                    |  |                |        |          |  |               |     |               |  |             |        |               |  |           |     |   |  |   |         |   |  |   |          |   |  |   |          |  
|--------------------------------------------------------------------------------------------------- |  | -------------- | ------ | -------- |  | ------------- | --- | ------------- |  | ----------- | ------ | ------------- |  | --------- | --- | - |  | - | ------- | - |  | - | -------- | - |  | - | -------- | -
|                                                                                                    |  |                |        |          |  | Accumulated   |     |               |  |             |        |              
|                                                                                                    |  | Common Stock   |        |          |  | Other         |     | Additional    |  |             |        | Stockholders
|                                                                                                    |  |                |        | Deferred |  | Comprehensive |     | Paid-In       |  | Accumulated |        | Equity       
|                                                                                                    |  | Shares         |        | Amount   |  | Compensation  |     | Income (Loss) |  | Capital     |        | Deficit       |  | (Deficit)
|                                                                                                    |  |                |        |          |  |               |     |               |  |             |        |               |  |          
|                                                                                                    |  |               
|                                                                                                    |  | (In thousands)
|Balance at July 31, 2001                                                                            |  |                | 4,125  |          |  | $             | 41  |               |  | $           |       |               |  | $         |    |   |  | $ | 208,642 |   |  | $ | (215,645 | ) |  | $ | (6,962   | )
|Issuance of common stock pursuant to employee
    stock purchase plan and exercise of stock options |  |                | 35     |          |  |               | 0   |               |  |             |       |               |  |           |    |   |  |   | 36      |   |  |   |         |   |  |   | 36       |  
|Conversion of CMGI convertible debt and other
    amounts due to CMGI                               |  |                | 1,624  |          |  |               | 16  |               |  |             |       |               |  |           |    |   |  |   | 87,137  |   |  |   |         |   |  |   | 87,153   |  
|Issuance of common stock in connection with the
    interest on convertible debt                    |  |                | 464    |          |  |               | 5   |               |  |             |       |               |  |           |    |   |  |   | 2,980   |   |  |   |         |   |  |   | 2,985    |  
|Beneficial conversion feature of debt issued to
    CMGI and HPFS                                   |  |                |       |          |  |               |    |               |  |             |       |               |  |           |    |   |  |   | 42,561  |   |  |   |         |   |  |   | 42,561   |  
|Net settlement of debt to CMGI                                                                      |  |                |       |          |  |               |    |               |  |             |       |               |  |           |    |   |  |   | 4,464   |   |  |   |         |   |  |   | 4,464    |  
|Net loss                                                                                            |  |                |       |          |  |               |    |               |  |             |       |               |  |           |    |   |  |   |        |   |  |   | (121,693 | ) |  |   | (121,693 | )
|                                                                                                    |  |                |        |          |  |               |     |               |  |             |        |               |  |           |     |   |  |   |         |   |  |   |          |   |  |   |          |  
|Balance at July 31, 2002                                                                            |  |                | 6,248  |          |  |               | 62  |               |  |             |       |               |  |           |    |   |  |   | 345,820 |   |  |   | (337,338 | ) |  |   | 8,544    |  
|Exercise of common stock options                                                                    |  |                | 2      |          |  |               |    |               |  |             |       |               |  |           |    |   |  |   | 2       |   |  |   |         |   |  |   | 2        |  
|Common control merger with CBTM                                                                     |  |                | 568    |          |  |               | 6   |               |  |             |       |               |  |           |    |   |  |   | 3,360   |   |  |   | (515     | ) |  |   | 2,851    |  
|Common control merger with CBT                                                                      |  |                |       |          |  |               |    |               |  |             |       |               |  |           |    |   |  |   | 16,664  |   |  |   | (4,259   | ) |  |   | 12,405   |  
|Conversion of CBT convertible debt and other
    amounts due to CBT                                 |  |                | 16,363 |          |  |               | 165 |               |  |             |       |               |  |           |    |   |  |   | 65,816  |   |  |   |         |   |  |   | 65,981   |  
|Issuance of common stock  Avasta
    acquisition                                                   |  |                | 231    |          |  |               | 2   |               |  |             |       |               |  |           |    |   |  |   | 367     |   |  |   |         |   |  |   | 369      |  
|Issuance of stock warrants to Silicon Valley Bank                                                   |  |                |       |          |  |               |    |               |  |             |       |               |  |           |    |   |  |   | 370     |   |  |   |         |   |  |   | 370      |  
|Currency translation adjustment                                                                     |  |                |       |          |  |               |    |               |  |             |       |               |  |           | (16 | ) |  |   |        |   |  |   |         |   |  |   | (16      | )
|Net loss                                                                                            |  |                |       |          |  |               |    |               |  |             |       |               |  |           |    |   |  |   |        |   |  |   | (73,627  | ) |  |   | (73,627  | )
|                                                                                                    |  |                |        |          |  |               |     |               |  |             |        |               |  |           |     |   |  |   |         |   |  |   |          |   |  |   |          |  
|Balance at July 31, 2003                                                                            |  |                | 23,412 |          |  |               | 235 |               |  |             |       |               |  |           | (16 | ) |  |   | 432,399 |   |  |   | (415,739 | ) |  |   | 16,879   |  
|Exercise of common stock options                                                                    |  |                | 159    |          |  |               | 1   |               |  |             |       |               |  |           |    |   |  |   | 403     |   |  |   |         |   |  |   | 404      |  
|Deferred stock-based compensation                                                                   |  |                |       |          |  |               |    |               |  |             | (1,987 | )             |  |           |    |   |  |   | 1,987   |   |  |   |         |   |  |   |         |  
|Amortization of deferred stock-based compensation                                                   |  |                |       |          |  |               |    |               |  |             | 473    |               |  |           |    |   |  |   |        |   |  |   |         |   |  |   | 473      |  
|Issuance of common stock  Avasta
    earn-out                                                      |  |                | 179    |          |  |               | 2   |               |  |             |       |               |  |           |    |   |  |   | 741     |   |  |   |         |   |  |   | 743      |  
|Issuance of stock warrants to Silicon Valley Bank                                                   |  |                |       |          |  |               |    |               |  |             |       |               |  |           |    |   |  |   | 213     |   |  |   |         |   |  |   | 213      |  
|Exercise of Silicon Valley Bank stock warrants                                                      |  |                | 74     |          |  |               | 1   |               |  |             |       |               |  |           |    |   |  |   | (1      | ) |  |   |         |   |  |   |         |  
|Issuance of common stock  common
    control merger with CBT                                       |  |                | 1,100  |          |  |               | 10  |               |  |             |       |               |  |           |    |   |  |   | 2,794   |   |  |   | (2,761   | ) |  |   | 43       |  
|Issuance of common stock  Surebridge
    acquisition                                               |  |                | 3,000  |          |  |               | 30  |               |  |             |       |               |  |           |    |   |  |   | 13,620  |   |  |   |         |   |  |   | 13,650   |  
|Currency translation adjustment                                                                     |  |                |       |          |  |               |    |               |  |             |       |               |  |           | 31  |   |  |   |        |   |  |   |         |   |  |   | 31       |  
|Net loss                                                                                            |  |                |       |          |  |               |    |               |  |             |       |               |  |           |    |   |  |   |        |   |  |   | (21,354  | ) |  |   | (21,354  | )
|                                                                                                    |  |                |        |          |  |               |     |               |  |             |        |               |  |           |     |   |  |   |         |   |  |   |          |   |  |   |          |  
|Balance at July 31, 2004                                                                            |  |                | 27,924 |          |  | $             | 279 |               |  | $           | (1,514 | )             |  | $         | 15  |   |  | $ | 452,156 |   |  | $ | (439,854 | ) |  | $ | 11,082   |  
|                                                                                                    |  |                |        |          |  |               |     |               |  |             |        |               |  |           |     |   |  |   |         |   |  |   |          |   |  |   |          |  

See accompanying notes to consolidated financial
statements.

F-5



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##### Table of Contents






NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                      |                                                                                  |                                                                                |                                           |                                        |        |        |        |         |        |        |         |          |        |         |         |  
|------------------------------------- | -------------------------------------------------------------------------------- | ------------------------------------------------------------------------------ | ----------------------------------------- | -------------------------------------- | ------ | ------ | ------ | ------- | ------ | ------ | ------- | -------- | ------ | ------- | ------- | -
|                                      |                                                                                  |                                                                               
|                                      |                                                                                  | Years Ended July 31,                                                          
|                                      |                                                                                  |                                                                               
|                                      |                                                                                  | 2004                                                                           |                                           | 2003                                   |        | 2002  
|                                      |                                                                                  |                                                                                |                                           |                                        |        |       
|                                      |                                                                                  |                                                                               
|                                      |                                                                                  | (In thousands)                                                                
|Cash flows from operating activities: |                                                                                  |                                                                                |                                           |                                        |        |        |        |         |        |        |         |         
|                                      | Net loss                                                                         |                                                                                | $                                         | (21,354                                | )      |        | $      | (73,627 | )      |        | $       | (121,693 | )     
|                                      | Adjustments to reconcile net loss to net cash
    used for operating activities: |                                                                                |                                           |                                        |        |        |        |         |        |        |         |          |       
|                                      |                                                                                  | Depreciation and amortization                                                  |                                           |                                        | 12,902 |        |        |         | 14,148 |        |         |          | 20,649 |        
|                                      |                                                                                  | Amortization of beneficial conversion feature to
    interest expense          |                                           |                                        |       |        |        |         | 37,398 |        |         |          | 5,163  |        
|                                      |                                                                                  | Interest on debt paid in stock                                                 |                                           |                                        |       |        |        |         | 2,098  |        |         |          | 3,695  |        
|                                      |                                                                                  | Impairment of long-lived assets                                                |                                           |                                        | 1,145  |        |        |         | 1,190  |        |         |          | 68,317 |        
|                                      |                                                                                  | Impairment of goodwill and intangibles                                         |                                           |                                        |       |        |        |         | 1,831  |        |         |          | 186    |        
|                                      |                                                                                  | Write-down of assets held for sale                                             |                                           |                                        |       |        |        |         |       |        |         |          | 524    |        
|                                      |                                                                                  | Loss on disposal of assets                                                     |                                           |                                        | 6      |        |        |         | 250    |        |         |          | 1,363  |        
|                                      |                                                                                  | Gain on sale of Streaming Media assets                                         |                                           |                                        |       |        |        |         |       |        |         |          | (524   | )      
|                                      |                                                                                  | Costs associated with abandoned leases                                         |                                           |                                        | 5,058  |        |        |         | 6,127  |        |         |          |       |        
|                                      |                                                                                  | Amortization of warrants                                                       |                                           |                                        | 358    |        |        |         | 66     |        |         |          |       |        
|                                      |                                                                                  | Non-cash stock compensation                                                    |                                           |                                        | 473    |        |        |         |       |        |         |          |       |        
|                                      |                                                                                  | Provision for bad debts                                                        |                                           |                                        | 2,568  |        |        |         | 1,583  |        |         |          | 3,490  |        
|                                      |                                                                                  | Accretion of debt discount                                                     |                                           |                                        |       |        |        |         |       |        |         |          | 1,172  |        
|                                      |                                                                                  | Changes in operating assets and liabilities, net
    of impact of acquisitions |                                           |                                        |        |        |        |         |        |        |         |          |        |        
|                                      |                                                                                  |                                                                                | Accounts receivable                       |                                        |        | 586    |        |         |        | (1,371 | )       |          |        | 3,600   |        
|                                      |                                                                                  |                                                                                | Unbilled accounts receivable              |                                        |        | (360   | )      |         |        | 45     |         |          |        |        |        
|                                      |                                                                                  |                                                                                | Due from CMGI and affiliates              |                                        |        |       |        |         |        | (22    | )       |          |        | (266    | )      
|                                      |                                                                                  |                                                                                | Due to CMGI                               |                                        |        |       |        |         |        | (3,241 | )       |          |        | 7,218   |        
|                                      |                                                                                  |                                                                                | Due from CBT                              |                                        |        | (101   | )      |         |        |       |         |          |        |        |        
|                                      |                                                                                  |                                                                                | Prepaid expenses and other current assets |                                        |        | (79    | )      |         |        | 1,775  |         |          |        | 178     |        
|                                      |                                                                                  |                                                                                | Long-term assets                          |                                        |        | 498    |        |         |        | 675    |         |          |        | (379    | )      
|                                      |                                                                                  |                                                                                | Accounts payable                          |                                        |        | (814   | )      |         |        | (2,614 | )       |          |        | (8,537  | )      
|                                      |                                                                                  |                                                                                | Customer deposits                         |                                        |        | (1     | )      |         |        | 192    |         |          |        | (19     | )      
|                                      |                                                                                  |                                                                                | Long-term liabilities                     |                                        |        | (844   | )      |         |        | 163    |         |          |        |        |        
|                                      |                                                                                  |                                                                                | Accrued expenses and deferred revenue     |                                        |        | (4,687 | )      |         |        | (1,215 | )       |          |        | (11,172 | )      
|                                      |                                                                                  |                                                                                |                                           |                                        |        |        |        |         |        |        |         |         
|                                      |                                                                                  |                                                                                |                                           | Net cash used for operating activities |        |        | (4,646 | )       |        |        | (14,549 | )        |        |         | (27,035 | )
|                                      |                                                                                  |                                                                                |                                           |                                        |        |        |        |         |        |        |         |         



(Continued)


F-6



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##### Table of Contents



|                                                  |                                                                              |                                           |       |        |        |      |         |        |        |   |        |        |        |  
|------------------------------------------------- | ---------------------------------------------------------------------------- | ----------------------------------------- | ----- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------ | ------ | ------ | -
|                                                  |                                                                              |                                          
|                                                  |                                                                              | Years Ended July 31,                     
|                                                  |                                                                              |                                          
|                                                  |                                                                              | 2004                                      |       | 2003   |        | 2002
|                                                  |                                                                              |                                           |       |        |        |     
|                                                  |                                                                              |                                          
|                                                  |                                                                              | (In thousands)                           
|Cash flows from investing activities:             |                                                                              |                                           |       |        |        |      |         |        |        |   |        |       
|                                                  | Net cash acquired in acquisitions                                            |                                           |       | 6      |        |      |         | 3,981  |        |   |        |       |       
|                                                  | Cash used to acquire Interliant assets                                       |                                           |       |       |        |      |         | (5,830 | )      |   |        |       |       
|                                                  | Purchase of property and equipment                                           |                                           |       | (4,269 | )      |      |         | (1,067 | )      |   |        | (4,182 | )     
|                                                  | Proceeds from the sale of equipment                                          |                                           |       | 95     |        |      |         | 475    |        |   |        | 1,440  |       
|                                                  | Purchase of debt securities                                                  |                                           |       |       |        |      |         | (1,963 | )      |   |        |       |       
|                                                  | Loan to related party                                                        |                                           |       |       |        |      |         | (1,596 | )      |   |        |       |       
|                                                  | Proceeds from repayment of loan to related party                             |                                           |       |       |        |      |         | 200    |        |   |        |       |       
|                                                  | Proceeds from the sale of Streaming Media assets                             |                                           |       |       |        |      |         |       |        |   |        | 1,600  |       
|                                                  | Other assets                                                                 |                                           |       |       |        |      |         |       |        |   |        | 577    |       
|                                                  |                                                                              |                                           |       |        |        |      |         |        |        |   |        |       
|                                                  |                                                                              | Net cash used for investing activities    |       |        | (4,168 | )    |         |        | (5,800 | ) |        |        | (565   | )
|                                                  |                                                                              |                                           |       |        |        |      |         |        |        |   |        |       
|Cash flows from financing activities:             |                                                                              |                                           |       |        |        |      |         |        |        |   |        |       
|                                                  | Restricted cash                                                              |                                           |       | 1,676  |        |      |         | 3,878  |        |   |        | 1,201  |       
|                                                  | Issuance of convertible notes payable to CMGI and
    HPFS                   |                                           |       |       |        |      |         |       |        |   |        | 30,000 |       
|                                                  | Proceeds from exercise of stock options and
    employee stock purchase plan |                                           |       | 404    |        |      |         |       |        |   |        | 35     |       
|                                                  | Proceeds from sale leaseback                                                 |                                           |       | 120    |        |      |         |       |        |   |        |       |       
|                                                  | Proceeds from note payable                                                   |                                           |       | 450    |        |      |         |       |        |   |        |       |       
|                                                  | Repayment of note payable                                                    |                                           |       | (2,055 | )      |      |         |       |        |   |        | (1,874 | )     
|                                                  | Debt repayment to the AppliedTheory estate                                   |                                           |       |       |        |      |         | (6,100 | )      |   |        |       |       
|                                                  | Borrowing under note to affiliate                                            |                                           |       |       |        |      |         | 5,850  |        |   |        |       |       
|                                                  | Net borrowings (repayments) under accounts
    receivable line               |                                           |       | (6,874 | )      |      |         | 6,359  |        |   |        |       |       
|                                                  | Net proceeds from modified accounts receivable
    line                      |                                           |       | 20,400 |        |      |         |       |        |   |        |       |       
|                                                  | Payments under note to affiliates                                            |                                           |       | (30    | )      |      |         | (2,600 | )      |   |        |       |       
|                                                  | Payoff of Surebridge line of credit and term note                            |                                           |       | (3,865 | )      |      |         |       |        |   |        |       |       
|                                                  | Payments on capital lease obligations                                        |                                           |       | (2,079 | )      |      |         | (5,018 | )      |   |        | (1,218 | )     
|                                                  | Payments of software vendor obligations                                      |                                           |       |       |        |      |         |       |        |   |        | (916   | )     
|                                                  |                                                                              |                                           |       |        |        |      |         |        |        |   |        |       
|                                                  |                                                                              | Net cash provided by financing activities |       |        | 8,147  |      |         |        | 2,369  |   |        |        | 27,228 |  
|                                                  |                                                                              |                                           |       |        |        |      |         |        |        |   |        |       
|Net decrease in cash                              |                                                                              |                                           | (667  | )      |        |      | (17,980 | )      |        |   | (372   | )     
|Cash and cash equivalents, beginning of year      |                                                                              |                                           | 3,862 |        |        |      | 21,842  |        |        |   | 22,214 |       
|                                                  |                                                                              |                                           |       |        |        |      |         |        |        |   |        |       
|Cash and cash equivalents, end of year            |                                                                              | $                                         | 3,195 |        |        | $    | 3,862   |        |        | $ | 21,842 |       
|                                                  |                                                                              |                                           |       |        |        |      |         |        |        |   |        |       
|Supplemental disclosure of cash flow information: |                                                                              |                                           |       |        |        |      |         |        |        |   |        |       
|                                                  | Cash paid for interest                                                       |                                           | $     | 1,898  |        |      | $       | 2,263  |        |   | $      | 3,553  |       
|                                                  |                                                                              |                                           |       |        |        |      |         |        |        |   |        |       

See accompanying notes to consolidated financial
statements.

F-7



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##### Table of Contents






NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS



|    |                        
|--- | -----------------------
|(1) | Description of Business

NaviSite, Inc. (Navisite, the
Company, we, us or
our) provides managed application services and a
broad range of outsourced hosting services for middle-market
organizations, which include mid-sized companies, divisions of
large multi-national companies and government agencies. Our
service offerings allow our customers to outsource the hosting
and management of their information technology infrastructure
and applications, such as commerce systems, enterprise software
applications and email. Substantially all revenues are generated
from customers in the United States.



|    |                                               
|--- | ----------------------------------------------
|(2) | Summary of Significant Accounting
    Policies



|    |                      
|--- | ---------------------
|(a) | Basis of Presentation



| |                                                                                                        
| | -------------------------------------------------------------------------------------------------------
| | Restatement of Previously Filed Financial
    Statements as of and for the Year Ended July 31,
    2003

We completed a business combination with CBT, an
entity under common control, on August 8, 2003, which was
after our fiscal year ending July 31, 2003 and disclosed as
a subsequent event in the notes to our 2003 financial
statements. As our fiscal 2004 operating results include the
results of CBT, our fiscal year 2003 financial statements, as
previously filed in our 2003 Form 10-K, have been restated
herein to account for this business combination in a manner
similar to a pooling of interests from September 11, 2002,
which was the common control effective date.



| |                                    
| | -----------------------------------
| | One-for-fifteen Reverse Stock Split

On December 12, 2002, our Board of
Directors, pursuant to authority previously granted by our
stockholders at the annual meeting on December 19, 2001,
approved a reverse stock split of our common stock at a ratio of
one-for-fifteen (1:15) effective January 7, 2003. All
per-share amounts and number of shares outstanding have been
restated to give effect to the reverse stock split.



| |                                
| | -------------------------------
| | Change in Controlling Ownership

Through September 10, 2002, we were a
majority-owned subsidiary of CMGI, Inc. (CMGI). On
September 11, 2002, each of CMGI and Hewlett-Packard
Financial Services Company (HPFS) sold and transferred to
ClearBlue Technologies, Inc. (ClearBlue), a privately-held
managed service provider based in San Francisco,
California, the following equity and debt interests in NaviSite:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Pursuant to a Note and Stock Purchase Agreement
    by and between ClearBlue and CMGI (the CMGI Agreement), CMGI
    sold and transferred to ClearBlue 4,735,293 shares of our
    common stock, $0.01 par value per share, representing
    approximately 76% of the outstanding capital stock of NaviSite,
    warrants to purchase 346,883 shares of our common
    stock and a convertible note of NaviSite with an aggregate
    principal amount outstanding of $10.0 million. The
    $10.0 million convertible note was convertible into
    2,564,103 shares of our common stock, under certain
    circumstances as defined therein.
|
| |  | Pursuant to a Note and Stock Purchase Agreement
    by and between ClearBlue and HPFS (the HPFS Agreement), HPFS
    sold and transferred to ClearBlue 213,804 shares of our
    common stock, representing approximately 3.4% of our outstanding
    capital stock, and convertible notes of NaviSite with an
    aggregate principal amount outstanding of approximately
    $55.0 million, convertible into 14,126,496 shares of
    our common stock, under certain circumstances as defined therein.                                                                                                                                     

On December 12, 2002, ClearBlue Finance,
Inc., a wholly-owned subsidiary of ClearBlue (ClearBlue
Finance), (i) converted in full the $10.0 million note
formerly held by CMGI and (ii) converted $10.0 million
of the $55.0 million notes formerly held by HPFS. We issued
5,128,205 shares of our common stock to ClearBlue Finance
upon the conversion and partial conversion, respectively, of the
$10.0 million note formerly held by CMGI and
$10.0 million of the $55.0 million notes formerly held
by HPFS and issued 458,943 shares

F-8



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

of our common stock for payments of interest due
under the convertible notes. A new note (New Note) in the amount
of $45.0 million was issued to ClearBlue Finance with
respect to the portion of the outstanding principal and interest
due under the note formerly held by HPFS that was not converted.

On December 13, 2002, ClearBlue transferred
beneficial ownership of all of its shares of our common stock
(except for a fractional share which it retained) to its
shareholders, ClearBlue Atlantic, LLC (ClearBlue Atlantic),
HPFS, CMGI and an employee of ClearBlue Technologies Management,
Inc. (CBTM) on a pro rata basis according to its
shareholders ownership of ClearBlue.

Also, as a result of the change in ownership, the
agreement between NaviSite and CMGI, whereby CMGI provided
certain facilities and administrative support services for us,
automatically terminated. CMGI continued to provide certain
services to us pursuant to a Transition Services Agreement we
entered into with CMGI on November 25, 2002 as we
transitioned to a service agreement with ClearBlue or to other
third-party suppliers. This transition agreement concluded
during the second quarter of fiscal year 2003, and we have
completely severed our administrative ties with CMGI; however,
CMGI remains a third-party customer.

On December 31, 2002, NaviSite, a majority
owned subsidiary of ClearBlue and its affiliates, completed the
acquisition of CBTM, a wholly-owned subsidiary of ClearBlue
which, in June 2002, acquired certain assets from the bankrupt
estate of AppliedTheory, Inc., in exchange for
567,978 shares of our common stock, representing 4.5% of
our total then outstanding common stock, inclusive of the common
stock issued as part of the acquisition. The market price of our
stock at the time of the transaction was $2.25 per share.
As ClearBlue had a controlling interest in both companies at the
time of the combination, the transaction was accounted for as a
combination of entities under common control (i.e., as if
pooling) whereby the assets and liabilities of CBTM and
NaviSite were combined at their historical amounts. Accordingly,
our historical consolidated financial statements for the quarter
ended October 31, 2002 have been restated to include the
financial results of CBTM beginning on September 11, 2002,
the initial date on which ClearBlue acquired a controlling
interest in both NaviSite and CBTM. CBTMs balance sheet
has been included in our Consolidated Balance Sheet at
July 31, 2003, and CBTMs results of operations and
cash flows for the eleven-months ended July 31, 2003 have
been included in our Consolidated Statements of Operations and
Consolidated Statements of Cash Flows for the fiscal year ended
July 31, 2003 and for all subsequent periods. CBTM is
operated as a wholly-owned subsidiary of NaviSite.

On June 16, 2003, we repaid approximately
$3.9 million of the $45.0 million outstanding New Note
to ClearBlue Finance, Inc. by offsetting amounts due to us by
ClearBlue. On June 17, 2003, we received written notice
from ClearBlue Finance, Inc. stating its election to convert the
remaining approximately $41.1 million of the New Note into
10,559,248 shares of common stock effective June 19,
2003. As of July 31, 2003 ClearBlue Technologies Equity,
Inc., ClearBlue Finance, ClearBlue and ClearBlue Atlantic
beneficially owned 19,284,994 shares of our common stock,
representing approximately 78.6% of the outstanding shares of
common stock on a fully converted basis. As a result of these
changes in ownership since September 11, 2002 involving
ClearBlue and its affiliates, the utilization of our federal and
state tax net operating loss carryforwards will be severely
limited pursuant to Internal Revenue Code Section 382.



| |                       
| | ----------------------
| | Impact of Acquisitions

During fiscal year 2004, we completed the
acquisition of substantially all of the assets of Surebridge,
Inc. (Surebridge) through our wholly-owned subsidiary, Lexington
Acquisition Corp. (Lexington). This acquisition was accounted
for using the purchase method of accounting. The results of
operations and cash flows from Surebridge are included in our
Consolidated Statement of Operations and Consolidated Statement
of Cash Flows for the twelve-month period ended July 31,
2004, from its acquisition date of June 10, 2004. See
Note 8 for further discussion of this fiscal year 2004
acquisition.

F-9



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

In addition to the acquisition of CBTM, as
discussed above, during fiscal year 2003, we acquired Avasta,
Inc. (Avasta), Conxion Corporation (Conxion), and substantially
all of the assets of Interliant, Inc. (Interliant Assets)
through our wholly-owned subsidiary, Intrepid Acquisition Corp.
(Intrepid). Each of these acquisitions was accounted for using
the purchase method of accounting. The results of operations and
cash flows from Avasta, Conxion, and Intrepid are included in
our Consolidated Statements of Operations and Consolidated
Statements of Cash Flows for the twelve-month period ended
July 31, 2003 from their respective dates of acquisition,
February 5, 2003, April 2, 2003, and May 16, 2003
and for all subsequent periods. See Note 8 for further
discussion of our fiscal year 2003 acquisitions.

On August 8, 2003, we completed the
acquisition of certain assets and the assumption of certain
liabilities of ClearBlue Technologies, Inc. (CBT) pursuant to a
Stock and Asset Acquisition Agreement (the CBT Agreement).
We acquired all outstanding shares of six (6) wholly-owned
subsidiaries of CBT with data centers located in Chicago, Las
Vegas, Los Angeles, Milwaukee, Oak Brook and Vienna. In
addition, we assumed the revenue and expense, as of the date of
acquisition, of four (4) additional wholly-owned
subsidiaries of CBT with data centers located in Dallas, New
York, San Francisco and Santa Clara (collectively the
Four Subsidiaries or the Deferred
Entities). Ownership of these subsidiaries transferred to
NaviSite for no additional consideration in April 2004, as
described below. The operational results of the Four
Subsidiaries have been included herein since NaviSite exercised
effective control over these subsidiaries as of August 8,
2003.

As Atlantic Investors, LLC had a controlling
interest in both NaviSite and CBT at the time of the
combination, the transaction was accounted for as a combination
of entities under common control (i.e., as if
pooling) whereby the assets and liabilities of CBT and
NaviSite were combined at their historical amounts. Accordingly,
our consolidated financial statements have been restated for all
periods prior to the business combination to include CBTs
financial results beginning on September 11, 2002, the date
on which CBT acquired the controlling interest in NaviSite,
after the elimination of intercompany balances. See Note 8
for further discussion of our fiscal year 2003 and 2004
acquisitions.

On February 6, 2004, we entered into an
amendment to the CBT Agreement (the Amendment) by
and among NaviSite, CBT and certain of CBTs wholly-owned
subsidiaries. The Amendment amended the CBT Agreement dated
August 8, 2003 to extend the date by which we are able to
cause the transfer to us of the Deferred Entities, from
February 8, 2004 to anytime on or prior to August 8,
2005 (the Transfer Date), under certain conditions
and for no additional consideration. In consideration for such
Amendment, we agreed to operate and manage the Deferred Entities
in a manner consistent with the CBT Agreement. On April 12,
2004, pursuant to the Amendment, NaviSite exercised its right to
acquire from CBT all of the outstanding shares of the Deferred
Entities, for no additional consideration.



|    |                            
|--- | ---------------------------
|(b) | Principles of Consolidation

The accompanying consolidated financial
statements include the accounts of NaviSite, Inc. and our wholly
owned subsidiaries, ClickHear, Inc., NaviSite Acquisition Corp.,
ClearBlue Technologies Management, Inc., Avasta, Inc., Conxion
Corporation, Intrepid Acquisition Corp., ClearBlue Technologies/
Chicago-Wells, Inc., ClearBlue Technologies/ Las Vegas, Inc.,
ClearBlue Technologies/ Los Angeles, Inc., ClearBlue
Technologies/ Milwaukee, Inc., ClearBlue Technologies/ Oak
Brook, Inc., and ClearBlue Technologies/ Vienna, Inc., ClearBlue
Technologies/ New York, Inc., ClearBlue Technologies/ Dallas,
Inc., ClearBlue Technologies/ Santa Clara, Inc., ClearBlue
Technologies/ San Francisco, Inc. and Lexington Acquisition
Corp. after elimination of all significant intercompany balances
and transactions.



|    |                 
|--- | ----------------
|(c) | Use of Estimates

The preparation of financial statements in
conformity with accounting principles generally accepted in the
United States of America requires management to make estimates
and assumptions that affect certain

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NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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 periods. Actual results could
differ from those estimates. Significant estimates made by
management include the useful lives of fixed assets and
intangible assets, recoverability of long-lived assets and the
collectability of receivables.



|    |                                                  
|--- | -------------------------------------------------
|(d) | Cash and Cash Equivalents and Restricted
    Cash

The Company considers all highly liquid
securities with original maturities of three months or less to
be cash equivalents. The Company had restricted cash of
$1.8 million and $3.1 million at July 31, 2004
and 2003, respectively, which represents a cash collateral
requirement for standby letters of credit associated with
several of the Companys facility and equipment leases.
Restricted cash declined during the year ended July 31,
2004, as the result of letters of credit that have expired, been
drawn down or canceled due to lease modifications.



|    |                    
|--- | -------------------
|(e) | Revenue Recognition

Revenue consists of monthly fees for Web site and
Internet application management, hosting, colocations and
professional services. The Company also derives revenue from the
sale of software and related maintenance contracts. Reimbursable
expenses charged to clients are included in revenue and cost of
revenue. Application management, hosting and colocation revenue
(other than installation fees) is billed and recognized over the
term of the contract, generally one to three years, based on
actual usage. Payments received in advance of providing services
are deferred until the period such services are provided.
Revenue from professional services, application management,
hosting and colocation revenue is recognized on either a
time-and material basis as the services are performed or under
the percentage of completion method for fixed-price contracts.
We generally sell our professional services under contracts with
terms ranging from one to five years. When current contract
estimates indicate that a loss is probable, a provision is made
for the total anticipated loss in the current period. Contract
losses are determined to be the amount by which the estimated
service costs of the contract exceed the estimated revenue that
will be generated by the contract. Unbilled accounts receivable
represents revenue for services performed that have not been
billed. Billings in excess of revenue recognized are recorded as
deferred revenue until the applicable revenue recognition
criteria are met. Revenue from the sale of software is
recognized when persuasive evidence of an arrangement exists,
the product has been delivered, the fees are fixed and
determinable and collection of the resulting receivable is
reasonably assured. In instances where the Company also provides
application management and hosting services in conjunction with
the sale of software, software revenue is deferred and
recognized ratably over the expected customer relationship
period. If we determine that collection of a fee is not
reasonably assured, we defer the fee and recognize revenue at
the time collection becomes reasonably assured, which is
generally upon receipt of cash.



|    |                             
|--- | ----------------------------
|(f) | Concentration of Credit Risk

Our financial instruments include cash, accounts
receivable, obligations under capital leases, software
agreements, accounts payable, and accrued expenses. As of
July 31, 2004, the carrying cost of these instruments
approximated their fair value. The financial instruments that
potentially subject us to concentration of credit risk consist
primarily of accounts receivable. Concentration of credit risk
with respect to trade receivables is limited due to the large
number of customers across many industries that comprise our
customer base. One third-party customer accounted for 12% and
21% of our total revenue for the fiscal year ended July 31,
2004 and 2003, respectively. During 2002, no third party
customer accounted for 10% or more of our total revenue.
Accounts receivable included approximately $1.5 million and
$2.3 million due from this third-party customer at
July 31, 2004 and 2003, respectively.

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



|    |                            
|--- | ---------------------------
|(g) | Comprehensive Income (Loss)

Comprehensive income (loss) is defined as the
change in equity of a business enterprise during a period of
time from transactions and other events and circumstances from
non-owner sources. The Company reports accumulated other
comprehensive income (loss), resulting from foreign currency
translation adjustments, in the Consolidated Statements of
Stockholders Equity.



|    |                       
|--- | ----------------------
|(h) | Property and Equipment

Property and equipment are stated at cost.
Depreciation is computed using the straight-line method over the
estimated useful lives of the assets, which range from three to
five years. Leasehold improvements and assets acquired under
capital leases are amortized using the straight-line method over
the shorter of the lease term or estimated useful life of the
asset. Assets acquired under capital leases in which title
transfers to us at the end of the agreement are amortized over
the useful life of the asset. Expenditures for maintenance and
repairs are charged to expense as incurred.

Renewals and betterments, which materially extend
the life of assets, are capitalized and depreciated. Upon
disposal, the asset cost and related accumulated depreciation
are removed from their respective accounts and any gain or loss
is reflected within Other income (expense), net in our
Consolidated Statements of Operations.



|    |                                                      
|--- | -----------------------------------------------------
|(i) | Long-Lived Assets, Goodwill and Other
    Intangibles

The Company follows the provisions of Statement
of Financial Accounting Standards (SFAS)
No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets. This statement requires that long-lived
assets and certain indentifiable intangibles be reviewed for
impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable.
Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to undiscounted
future net cash flows expected to be generated by the asset. If
such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying
amount of the assets exceeds the fair value of the assets.
Assets to be disposed of are reported at the lower of the
carrying amount or fair value less cost to sell.

The Company reviews the valuation of goodwill in
accordance with SFAS No. 142 Goodwill and Other
Intangible Assets. Under the provisions of SFAS
No. 142, goodwill is required to be tested for impairment
annually in lieu of being amortized. This testing is done in the
fourth quarter of each year. Furthermore, goodwill is required
to be tested for impairment on an interim basis if an event or
circumstance indicates that it is more likely than not an
impairment loss has been incurred. An impairment loss shall be
recognized to the extent that the carrying amount of goodwill
exceeds its implied fair value. Impairment losses shall be
recognized in operations. The Companys valuation
methodology for assessing impairment requires management to make
judgments and assumptions based on historical experience and
projections of future operating performance. Management
predominantly uses third party valuation reports to assist in
its determination of the fair value. If these assumptions differ
materially from future results, the Company may record
impairment charges in the future.



|    |             
|--- | ------------
|(j) | Income Taxes

We account for income taxes under the asset and
liability method in accordance with SFAS No. 109,
Accounting for Income Taxes. Deferred tax assets and
liabilities are recognized for the future tax consequences
attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their
respective tax bases and operating loss and tax credit
carryforwards. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in
the years in

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

which those temporary differences are expected to
be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in
the period that includes the enactment date.



|    |                  
|--- | -----------------
|(k) | Advertising Costs

We recognize advertising costs as incurred.
Advertising expense was approximately $20,000, $0 and $4,000 for
the fiscal years ended July 31, 2004, 2003, and 2002,
respectively, and is included in the accompanying consolidated
statements of operations as a component of selling and marketing
expenses.



|    |                                   
|--- | ----------------------------------
|(l) | Stock-Based Compensation
    Plans

We account for our stock option plans under the
recognition and measurement principles of Accounting Principles
Board Opinion No. 25 (APB), Accounting for
Stock Issued to Employees, and Related Interpretations. We
recorded stock compensation expense of approximately $473,000,
$0 and $0 during the fiscal years ended July 31, 2004, 2003
and 2002, respectively (see Note 12). The following table
illustrates the effect on net loss and net loss per common share
if we had applied the fair value recognition provisions of
Financial Accounting Standards Board (FASB)
Statement No. 123, Accounting for Stock-Based
Compensation, to stock based compensation.

|                                                                                                                                             |                                 |                                       |         |       |   |      |         |       |   |   |          |        |  
|-------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------- | ------------------------------------- | ------- | ----- | - | ---- | ------- | ----- | - | - | -------- | ------ | -
|                                                                                                                                             |                                 | 2004                                  |         | 2003  |   | 2002
|                                                                                                                                             |                                 |                                       |         |       |   |     
|                                                                                                                                             |                                 |                                      
|                                                                                                                                             |                                 | (In thousands, except per share data)
|Net loss, as reported                                                                                                                        |                                 | $                                     | (21,354 | )     |   | $    | (73,627 | )     |   | $ | (121,693 | )     
|Add: Stock-based employee compensation expense
    from the Amended and Restated 2003 Stock Incentive Plan included
    in reported net loss |                                 |                                       | 473     |       |   |      |        |       |   |   |         |       
|Deduct: Total stock based employee compensation
    expense determined under fair value based method for all awards                          |                                 |                                       | (5,702  | )     |   |      | (8,062  | )     |   |   | (24,778  | )     
|                                                                                                                                             |                                 |                                       |         |       |   |      |         |       |   |   |          |       
|Net loss, as adjusted                                                                                                                        |                                 | $                                     | (26,583 | )     |   | $    | (81,689 | )     |   | $ | (146,471 | )     
|                                                                                                                                             |                                 |                                       |         |       |   |      |         |       |   |   |          |       
|Net loss per common share:                                                                                                                   |                                 |                                       |         |       |   |      |         |       |   |   |          |       
|                                                                                                                                             | Basic and diluted  as reported |                                       | $       | (0.85 | ) |      | $       | (6.32 | ) |   | $        | (22.30 | )
|                                                                                                                                             |                                 |                                       |         |       |   |      |         |       |   |   |          |       
|                                                                                                                                             | Basic and diluted  as adjusted |                                       | $       | (1.06 | ) |      | $       | (7.01 | ) |   | $        | (26.84 | )
|                                                                                                                                             |                                 |                                       |         |       |   |      |         |       |   |   |          |       

The fair value of each stock option grant has
been estimated on the date of grant using the Black-Scholes
option-pricing model, assuming no expected dividends and the
following weighted average assumptions:

|          |                                                                      |  |   |        |   |  |   |        |   |  |   |        |  
|--------- | -------------------------------------------------------------------- |  | - | ------ | - |  | - | ------ | - |  | - | ------ | -
|NaviSite: |                                                                      |  |   |        |   |  |   |        |   |  |   |       
|          | Risk-free interest rate                                              |  |   | 2.68   | % |  |   | 1.93   | % |  |   | 2.23   | %
|          | Expected volatility                                                  |  |   | 137.34 | % |  |   | 160.16 | % |  |   | 250.00 | %
|          | Expected life (years)                                                |  |   | 2.08   |   |  |   | 3.07   |   |  |   | 2.12   |  
|          | Weighted average fair value of options granted
    during the period |  | $ | 4.58   |   |  | $ | 2.23   |   |  | $ | 4.01   |  



|    |                                                                            
|--- | ---------------------------------------------------------------------------
|(m) | Historical and Unaudited Pro Forma Basic
    and Diluted Net Loss Per Share

Basic net loss per common share is computed using
the weighted average number of common shares outstanding during
the period. Diluted net loss per common share is computed using
the weighted average number of common and diluted common
equivalent shares outstanding during the period, using either
the if-converted method for convertible preferred
stock and notes or the treasury stock method for options, unless
amounts are anti-dilutive.

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

For fiscal years ended July 31, 2004, 2003,
and 2002, net loss per basic and diluted share is based on
weighted average common shares and excludes any common stock
equivalents, as they would be anti-dilutive due to the reported
losses. There were 970,748, 2,741 and 29,503 of diluted shares
related to employee stock options that were excluded as they
have an anti-dilutive effect due to the loss for fiscal years
2004, 2003 and 2002, respectively.



|    |                  
|--- | -----------------
|(n) | Segment Reporting

We currently operate in one segment, outsourced
hosting and application management services. The Companys
chief operating decision maker reviews financial information at
a consolidated level. The Company has determined that reporting
revenue at a service offering level is impracticable.



|    |                              
|--- | -----------------------------
|(o) | New Accounting Pronouncements

In November 2002, the Emerging Issues Task Force
(EITF) reached a consensus on EITF Issue 00-21,
Accounting for Revenue Arrangements with Multiple
Deliverables. EITF Issue 00-21 provides guidance on
how to determine when an arrangement that involves multiple
revenue-generating activities or deliverables should be divided
into separate units of accounting for revenue recognition
purposes, and if this division is required, how the arrangement
consideration should be allocated among the separate units of
accounting. The guidance in the consensus is effective for
revenue arrangements entered into on or after January 1,
2004. The adoption of EITF Issue 00-21 did not have a
material effect on the Companys financial position or
results of operations.

In January 2003, FASB Interpretation No.
(FIN) 46, Consolidation of Variable Interest
Entities, was issued. FIN 46 requires certain
variable interest entities (VIE) to be consolidated
by the primary beneficiary of the entity if the equity investors
in the entity do not have the characteristics of a controlling
financial interest or do not have sufficient equity at risk for
the entity to finance its activities without additional
subordinated financial support from other parties. FIN 46
is effective for all new VIEs created or acquired after
January 31, 2003. During December 2003, the FASB issued a
new revision to FIN 46 (FIN 46R).

Under the revised provisions, public entities are
required to apply the guidance if the entity has interests in
VIEs commonly referred to as special-purpose entities for the
periods ending after December 15, 2003. The adoption of
FIN 46 and 46R did not have a material effect on our
consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150,
Accounting For Certain Financial Instruments with
Characteristics of Both Liabilities and Equity, which
establishes standards for how an issuer of financial instruments
classifies and measures certain financial instruments with
characteristics of both liabilities and equity. It requires that
an issuer classify a financial instrument that is within its
scope as a liability (or an asset in some circumstances) if, at
inception, the monetary value of the obligation is based solely
or predominantly on a fixed monetary amount known at inception,
variations in something other than the fair value of the
issuers equity shares or variations inversely related to
changes in the fair value of the issuers equity shares.
This Statement is effective for financial instruments entered
into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning
after June 15, 2003. On November 7, 2003, the FASB
deferred the classification and measurement provisions of
SFAS No. 150 as they apply to certain mandatory
redeemable non-controlling interests. This deferral is expected
to remain in effect while these provisions are further evaluated
by the FASB. We have not entered into or modified any financial
instruments covered by this statement after May 31, 2003
and the application of this standard is not expected to have a
material impact on our financial position or results of
operations.

In December 2003, the Securities and Exchange
Commission (SEC) issued Staff Accounting Bulletin
No. (SAB) 104, Revenue Recognition,
which supersedes SAB 101, Revenue Recognition in
Financial Statements. SAB 104s primary purpose
is to rescind accounting guidance contained in SAB 101
related to

F-14



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

multiple element revenue arrangements, superseded
as a result of the issuance of EITF 00-21, Accounting
for Revenue Arrangements with Multiple Deliverables. The
issuance of SAB 104 reflects the concepts contained in
EITF 00-21; the other revenue recognition concepts
contained in SAB 101 remain largely unchanged. The
application of SAB 104 did not have a material impact on
the Companys financial position or results of operations.



|    |                 
|--- | ----------------
|(p) | Foreign Currency

The functional currencies of our wholly owned
subsidiaries are the local currencies. The financial statements
of the subsidiaries are translated into U.S. dollars using
period end exchange rates for assets and liabilities and average
exchange rates during corresponding periods for revenue, cost of
revenue and expenses. Translation gains and losses are deferred
and accumulated as a separate component of stockholders
equity (accumulated other comprehensive income (loss)).



|    |                  
|--- | -----------------
|(q) | Reclassifications

Certain fiscal year 2003 balances have been
reclassified to conform to the fiscal year 2004 financial
statement presentation.



|    |          
|--- | ---------
|(3) | Liquidity

As of July 31, 2004, our principal sources
of liquidity included cash and cash equivalents and our
financing agreement with Silicon Valley Bank. We had a working
capital deficit of $36.7 million, including cash and cash
equivalents of $3.2 million at July 31, 2004, as
compared to a working capital deficit of $16.3 million,
including cash and cash equivalents of $3.9 million, at
July 31, 2003.

The total net change in cash and cash equivalents
for the fiscal year ended July 31, 2004 was a decrease of
$0.7 million. The primary uses of cash during fiscal year
2004 included $4.6 million of cash used for operating
activities, $4.3 million for purchases of property and
equipment and $8.0 million in repayments on notes payable
and capital lease obligations. Our primary sources of cash
during fiscal year 2004 were a $1.7 million decrease in
restricted cash, $0.4 million in proceeds associated with
the exercise of stock options under the employee stock option
plans, $13.5 million in net proceeds from our financing
agreements and $0.6 million in proceeds from sale-leaseback
and note payable transactions. Net cash used for operating
activities of $4.6 million during the fiscal year ended
July 31, 2004, resulted primarily from our
$21.4 million net loss, partially offset by
$22.6 million in non-cash charges, and $5.8 million
used by net changes in operating assets and liabilities. At
July 31, 2004, we had an accumulated deficit of
$439.9 million, and have reported losses from operations
since incorporation. At July 31, 2003, we had an
accumulated deficit of $415.7 million.

Prior to May 2003, our primary sources of cash to
fund our operations were sales of equity and convertible debt
securities. Since May 2003, our primary source of cash to fund
our operations and meet our contacted obligations and
commitments has been our accounts receivable financing agreement
with Silicon Valley Bank. On January 30, 2004, we amended
this agreement to, among other things, allow for future
borrowing to be based on monthly recurring revenue, increase the
maximum borrowings level from $10.0 million to
$12.8 million, and extend the term until January 29,
2006. On April 29, 2004, we amended this agreement, among
other things, to increase the maximum borrowing level from
$12.8 million to $20.4 million, and extend the term
until April 29, 2006. Under the amended agreement,
borrowings are based on monthly recurring revenue. We are
required to prepare and deliver a written request for an advance
of up to three times the value of total monthly recurring
revenue, calculated to be monthly revenue (including revenue
from New York State Department of Labor) less professional
services revenue. The bank may then provide an advance of 85% of
such value (or such other percentage as the bank may determine).
The interest rate under the agreement is variable and is
currently calculated at the banks published prime
rate plus four percent. Following

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

completion of certain equity or debt financings,
and provided we continue to meet certain ratios under the
amended agreement, the interest rate shall be reduced to the
banks prime rate plus one percent. In no event, however,
will the prime rate be less than 4.25%. On July 31, 2004,
we had an outstanding balance under the amended agreement of
$20.4 million.

At July 31, 2004, the Company had
$1.8 million in outstanding standby letters of credit,
issued in connection with facility and equipment lease
agreements, which are 100% cash collateralized. Cash subject to
collateral requirements has been recorded as restricted cash and
is classified as non-current on our balance sheet at
July 31, 2004.

We anticipate that we will continue to incur net
losses in the future. We have taken several actions we believe
will allow us to continue as a going concern through
July 31, 2005, including the closing and integration of
strategic acquisitions, the changes to our senior management and
bringing costs more in line with projected revenue.
Additionally, we will need to find sources of financing in order
to remain a going concern. Potential sources include our
financing agreement with Silicon Valley Bank and public or
private sales of equity or debt securities. We are obligated to
use a significant portion of any proceeds raised in an equity or
debt financing to make payments on the Surebridge notes,
depending on the total net proceeds received by us in the
financing (see Note 11(f)). We may also consider sales of
assets to raise additional cash. If we use a significant portion
of the net proceeds from an offering to acquire a company,
technology or product, we will need to raise additional debt or
equity capital.

Our operating forecast incorporates material
trends, such as our acquisitions, reductions in workforce, loss
of related party revenue and closings of facilities. Our
forecast also incorporates the future cash flow benefits
expected from our continued efforts to increase efficiencies and
reduce redundancies. Nonetheless, our forecast includes the need
to raise additional funds. Our cash flow estimates are based
upon attaining certain levels of sales, maintaining budgeted
levels of operating expenses, collections of accounts receivable
and maintaining our current borrowing line with Silicon Valley
Bank among other assumptions, including the improvement in the
overall macroeconomic environment. However there can be no
assurance that we will be able to meet such assumptions. Our
sales estimate includes revenue from new and existing customers,
which may not be realized, and we may be required to further
reduce expenses if budgeted sales are not attained. We may be
unsuccessful in reducing expenses in proportion to any shortfall
in projected sales and our estimate of collections of accounts
receivable may be hindered by our customers ability to
pay. In addition, we are currently involved in various pending
and potential legal proceedings. While we believe that the
allegations against us in each of these matters are without
merit, and that we have a meritorious defense in each, we are
not able to predict the final outcomes of any of these matters
and the effect, if any, on our business, financial condition,
results of operations or cash flows. If we are ultimately
unsuccessful in any of these matters, we could be required to
pay substantial amounts of cash and/or shares of our common
stock to the other parties. The amount and timing of any such
payments could adversely affect our business, financial
condition, results of operations or cash flows.



|    |                                
|--- | -------------------------------
|(4) | Impairment of Long-Lived Assets

During fiscal year 2004, the Company recorded a
$1.1 million impairment charge including, a
$0.6 million impairment charge for furniture and fixtures
related to abandoned leases in Houston, Syracuse and
San Jose; a $0.2 million charge for capital
improvements to our impaired space at 400 Minuteman Road in
Andover, MA; and a $0.3 million charge related to the
impairment of furniture and fixtures in our facility at 55
Francisco Street, San Francisco, CA.

As a result of our abandoning our administrative
space located on the second floor of our leased facility at 400
Minuteman Road in Andover, MA on January 31, 2003, certain
long-lived assets consisting mostly of leasehold improvements
and furniture and fixtures were abandoned. We took a charge
against our earnings in

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

the second quarter of fiscal 2003 of
approximately $62,000 in accordance with SFAS 144,
Accounting for the Impairment or Disposal of Long-Lived
Assets.

During the third fiscal quarter of 2003, we
evaluated the net realizable value of our assets held for sale
and determined, based upon third party quotes for purchase of
these assets, that the net fair market value of our assets held
for sale was less than the carrying value. As a result, we
recorded a $1.0 million charge related to the reduction in
the net realizable value of our assets held for sale as a
component of other expense. These assets were sold to third
parties in the fourth fiscal quarter of 2003.

During fiscal 2003, CBT evaluated the net
realizable value of its long-lived assets and recorded an
impairment charge of approximately $2.0 million.

During fiscal year 2002, the Company recorded a
net $1.9 million charge representing the future estimated
remaining minimum lease payments related to certain idle
equipment held under various operating leases. The equipment had
previously been rented to former customers under operating
leases, and upon the loss of the customer, the equipment became
idle. Based on the Companys forecasts, the equipment will
not be utilized before the related operating leases expire
and/or the equipment becomes obsolete.

During fiscal year 2002, the Company evaluated
the current and forecasted utilization of its purchased software
licenses. As a result of this evaluation, during the second
quarter of fiscal year 2002, the Company recorded a $365,000
impairment for software licenses that would not be utilized
before the licenses expired or became obsolete.

During fiscal year 2002, the Company finalized
agreements with various equipment lessors whereby the Company
purchased equipment previously held under operating lease for
approximately $42.0 million, less amount owed under capital
leases at that time. The fair market value of the equipment at
the time of purchase, based on third party appraisal, was
approximately $13.1 million. As the aggregate fair market
value of the equipment, based on third party appraisal, was less
than the aggregate consideration given, the Company recorded an
asset impairment charge of $24.9 million, as a separate
component of cost of revenue, in fiscal year 2002.

A number of factors occurring during the fourth
quarter of fiscal 2002 impacted the Companys long-lived
assets including both their expected future cash flow generation
and the Companys expected utilization of the assets within
revised operating plans. These factors included the further
deterioration of market conditions within the web hosting
industry, excess capacity in the industry and in the
Companys two data centers, deterioration of the
Companys revenue base.

Based on these factors and their impact on
current and future projected cash flows, the Company performed
an assessment of the carrying value of its long-lived assets
pursuant to SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of. The conclusion of this assessment was that
the decline in market conditions within the Companys
industry were significant and other than temporary. In this
assessment, the Company reviewed its long-lived assets, which
included property and equipment and goodwill. The carrying
amount of goodwill, which totaled $186,000, was considered
unrecoverable and was written-off as of July 31, 2002 and
was included as a component of general and administration
expense.

F-17



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

In accordance with SFAS No. 121, the
measurement of the impairment loss of property and equipment was
based on the fair value of the asset, as determined by a third
party appraisal. The following is a summary of the impairment
charge, by asset classification, as of July 31, 2002:

|                               |       |                |        |            |  |            |       |        |  |   |        |        | 
|------------------------------ | ----- | -------------- | ------ | ---------- |  | ---------- | ----- | ------ |  | - | ------ | ------ | 
|                               |       |                |        | Appraised  |  |           
|                               |       | Carrying Value |        | Fair Value |  | Impairment
|                               |       |                |        |            |  |           
|                               |       |               
|                               |       | (In thousands)
|Office furniture and equipment |       | $              | 3,062  |            |  | $          | 837   |        |  | $ | 2,225  |       
|Computer equipment             |       |                | 8,470  |            |  |            | 5,675 |        |  |   | 2,795  |       
|Software licenses              |       |                | 3,720  |            |  |            | 2,158 |        |  |   | 1,562  |       
|Leasehold improvements         |       |                | 35,280 |            |  |            | 3,742 |        |  |   | 31,538 |       
|                               |       |                |        |            |  |            |       |        |  |   |        |       
|                               | Total |                | $      | 50,532     |  |            | $     | 12,412 |  |   | $      | 38,120 | 
|                               |       |                |        |            |  |            |       |        |  |   |        |       

In addition, approximately $3.0 million of
other impairment charges were recorded throughout fiscal year
2002.

Management determined that the best measure of
fair value for the property and equipment was a combination of
the market and cost approaches. The cost approach was utilized
to determine the fair value of certain computer hardware,
leasehold improvements, office furniture and equipment, and
construction in progress. The cost approach utilizes estimated
replacement/reproduction costs, with allowances for physical
depreciation and functional obsolescence (i.e. asset
utilization). For certain equipment and leasehold improvements,
the market approach was used. The market approach typically
includes comparing recent sales of similar assets and adjusting
these comparable transactions based on factors such as age,
condition, and type of sale to determine fair value.

The following is a summary of the fiscal 2002
impairment charges described above, by asset classification:

|                                                                                                               |       |   |        |        | 
|-------------------------------------------------------------------------------------------------------------- | ----- | - | ------ | ------ | 
|Net impairment of fixed assets purchased from
    operating leases                                             |       | $ | 24,881 |       
|Impairment of software that would not be utilized
    before expiration of license or software became obsolete |       |   | 365    |       
|Impairment of idle leased equipment                                                                            |       |   | 1,937  |       
|Impairment of fixed assets under SFAS 121
    based on the fair value of the assets versus the carrying value  |       |   | 41,134 |       
|                                                                                                               |       |   |        |       
|                                                                                                               | Total |   | $      | 68,317 | 
|                                                                                                               |       |   |        |       

All impairment charges were recorded in the
consolidated statements of operations based upon the nature of
the asset being impaired and the nature of the assets use.
The impairments recorded as a separate component of cost of
revenue related to assets that were either being utilized or had
at some time been utilized to generate revenue. The
determination was based upon how the assets had historically
been expensed, either as lease expense or
depreciation/amortization.

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



|    |                       
|--- | ----------------------
|(5) | Property and Equipment

Property and equipment are stated at cost.
Depreciation is computed using the straight-line method over the
estimated useful lives of the assets. Leasehold improvements and
assets acquired under capital leases are amortized using the
straight-line method over the shorter of the lease term or
estimated useful life of the asset. Assets acquired under
capital leases in which title transfers to us at the end of the
agreement are amortized over the useful life of the asset.
Expenditures for maintenance and repairs are charged to expense
as incurred. Property and equipment at July 31, 2004 and
2003 are summarized as follows:

|                                                |  |                |         |      |  |   |         |  
|----------------------------------------------- |  | -------------- | ------- | ---- |  | - | ------- | -
|                                                |  |               
|                                                |  | July 31,      
|                                                |  |               
|                                                |  | 2004           |         | 2003
|                                                |  |                |         |     
|                                                |  |               
|                                                |  | (In thousands)
|Office furniture and equipment                  |  | $              | 3,625   |      |  | $ | 2,613   |  
|Computer equipment                              |  |                | 35,117  |      |  |   | 28,368  |  
|Software licenses                               |  |                | 10,405  |      |  |   | 9,308   |  
|Leasehold improvements                          |  |                | 10,245  |      |  |   | 12,549  |  
|                                                |  |                |         |      |  |   |         |  
|                                                |  |                | 59,392  |      |  |   | 52,838  |  
|Less: Accumulated depreciation and amortization |  |                | (38,598 | )    |  |   | (30,673 | )
|                                                |  |                |         |      |  |   |         |  
|Property and equipment, net                     |  | $              | 20,794  |      |  | $ | 22,165  |  
|                                                |  |                |         |      |  |   |         |  

The estimated useful lives of our fixed assets
are as follows: office furniture and equipment, 5 years;
computer equipment, 3 years; software licenses,
3 years or life of the license; and leasehold improvements,
4 years or life of the lease.

The cost and related accumulated amortization of
property and equipment held under capital leases (classified as
computer equipment above) are as follows:

|                                          |  |                |        |      |  |   |        |  
|----------------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | -
|                                          |  |               
|                                          |  | July 31,      
|                                          |  |               
|                                          |  | 2004           |        | 2003
|                                          |  |                |        |     
|                                          |  |               
|                                          |  | (In thousands)
|Cost                                      |  | $              | 6,797  |      |  | $ | 6,349  |  
|Accumulated depreciation and amortization |  |                | (4,644 | )    |  |   | (2,181 | )
|                                          |  |                |        |      |  |   |        |  
|                                          |  | $              | 2,153  |      |  | $ | 4,168  |  
|                                          |  |                |        |      |  |   |        |  



|    |                  
|--- | -----------------
|(6) | Intangible Assets

Intangible assets consist of customer lists
resulting from our acquisitions of Avasta, Interliant and
Surebridge and the as if poolings of CBTM and CBT.
The gross carrying amount and accumulated amortization as of
July 31, 2004 and 2003 for customer lists are as follows:

|                         |  |                |        |      |  |   |        | 
|------------------------ |  | -------------- | ------ | ---- |  | - | ------ | 
|                         |  |               
|                         |  | July 31,      
|                         |  |               
|                         |  | 2004           |        | 2003
|                         |  |                |        |     
|                         |  |               
|                         |  | (In thousands)
|Gross carrying amount    |  | $              | 31,026 |      |  | $ | 15,776 | 
|Accumulated amortization |  |                | 7,875  |      |  |   | 3,724  | 
|                         |  |                |        |      |  |   |        | 
|Customer lists, net      |  | $              | 23,151 |      |  | $ | 12,052 | 
|                         |  |                |        |      |  |   |        | 

F-19



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Intangible asset amortization expense for the
years ended July 31, 2004, 2003 and 2002 aggregated
$3.8 million, $2.8 million and $0, respectively.
Amortization expense related to intangible assets for the next
five years is as follows:

|                     |  |                |       | 
|-------------------- |  | -------------- | ----- | 
|Year Ending July 31, |  | (In thousands)
|                     |  |               
|2005                 |  | $              | 5,630 | 
|2006                 |  | $              | 5,133 | 
|2007                 |  | $              | 4,189 | 
|2008                 |  | $              | 3,292 | 
|2009                 |  | $              | 2,064 | 

Customer lists are being amortized over estimated
useful lives ranging from five to eight years.



|    |         
|--- | --------
|(7) | Goodwill

The changes in the carrying amount of goodwill
for the fiscal years ended July 31 are as follows:

|                                               |  |                |        |        |  |        |       |  |  |   |      |  
|---------------------------------------------- |  | -------------- | ------ | ------ |  | ------ | ----- |  |  | - | ---- | -
|                                               |  | Fiscal         |        | Fiscal |  | Fiscal
|                                               |  | 2004           |        | 2003   |  | 2002  
|                                               |  |                |        |        |  |       
|                                               |  |               
|                                               |  | (In thousands)
|Goodwill as of August 1,                       |  | $              | 3,206  |        |  | $      |      |  |  | $ | 394  |  
|Goodwill  common control merger with
    CBTM |  |                |       |        |  |        | 3,206 |  |  |   |     |  
|Goodwill acquired                              |  |                | 42,714 |        |  |        |      |  |  |   |     |  
|Goodwill amortization                          |  |                |       |        |  |        |      |  |  |   | (208 | )
|Goodwill impairment                            |  |                |       |        |  |        |      |  |  |   | (186 | )
|                                               |  |                |        |        |  |        |       |  |  |   |      |  
|Goodwill as of July 31,                        |  | $              | 45,920 |        |  | $      | 3,206 |  |  | $ |     |  
|                                               |  |                |        |        |  |        |       |  |  |   |      |  

We perform our annual impairment analysis in our
fiscal fourth quarter. No goodwill impairment has been recorded
during fiscal year 2004 or 2003. As part of our impairment
analysis performed at July 31, 2002, it was determined that
the unamortized goodwill at July 31, 2002 of $186,000 was
fully impaired and was included in the accompanying consolidated
statements of operations as a component of general and
administrative expense.

The impact that the adoption of SFAS 142 had
on net income and earnings per share for the fiscal years ended
July 31 are presented as follows:

|                                                        |                                           |                |         |       |   |      |         |       |   |   |          |        |  
|------------------------------------------------------- | ----------------------------------------- | -------------- | ------- | ----- | - | ---- | ------- | ----- | - | - | -------- | ------ | -
|                                                        |                                           | 2004           |         | 2003  |   | 2002
|                                                        |                                           |                |         |       |   |     
|                                                        |                                           |               
|                                                        |                                           | (In thousands)
|Net loss                                                |                                           | $              | (21,354 | )     |   | $    | (73,627 | )     |   | $ | (121,693 | )     
|Add back: goodwill amortization expense, net of
    tax |                                           |                |        |       |   |      |        |       |   |   | 208      |       
|                                                        |                                           |                |         |       |   |      |         |       |   |   |          |       
|Adjusted net loss available to common stockholders      |                                           | $              | (21,354 | )     |   | $    | (73,627 | )     |   | $ | (121,485 | )     
|                                                        |                                           |                |         |       |   |      |         |       |   |   |          |       
|Basic and diluted earnings per share:                   |                                           |                |         |       |   |      |         |       |   |   |          |       
|                                                        | Net loss                                  |                | $       | (0.85 | ) |      | $       | (6.32 | ) |   | $        | (22.30 | )
|                                                        | Goodwill amortization expense, net of tax |                |         |      |   |      |         |      |   |   |          | 0.05   |  
|                                                        |                                           |                |         |       |   |      |         |       |   |   |          |       
|                                                        | Adjusted net loss                         |                | $       | (0.85 | ) |      | $       | (6.32 | ) |   | $        | (22.25 | )
|                                                        |                                           |                |         |       |   |      |         |       |   |   |          |       

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



|    |             
|--- | ------------
|(8) | Acquisitions

ClearBlue Technologies Management,
Inc.(CBTM).We acquired
CBTM in December 2002, in a transaction accounted for as a
combination of entities under common control (i.e., as if
pooling) (See Note 1). In June 2002, prior to our
acquisition of CBTM, CBTM acquired substantially all of the
assets used or useful in the Web hosting and Internet solutions
business and assumed certain associated liabilities from the
bankruptcy estate of AppliedTheory Corporation
(AppliedTheory), which had filed for bankruptcy on
April 17, 2002. On June 13, 2002, the acquisition of
AppliedTheory by CBTM was consummated, effective June 6,
2002. The results of operations of AppliedTheory have been
included in the financial statements of CBTM since June 6,
2002.

The aggregate purchase price paid by CBTM for the
AppliedTheory assets, excluding assumed liabilities, was
$16.0 million of which $3.9 million was paid in cash
and $12.1 million was paid with the issuance of four notes
payable to the AppliedTheory Estate: two unsecured promissory
notes totaling $6.0 million, bearing interest at
8% per annum and due June 10, 2006, a secured
promissory note totaling $700,000, bearing interest at
8% per annum and due December 10, 2002 and a
$5.4 million secured promissory note, non-interest bearing,
due December 10, 2002. The two notes due December 10,
2002 were paid in December 2002.

Of the $6.2 million in identifiable
intangible assets, $5.8 million was assigned to customer
lists which are being amortized over eight years, except for the
New York State Department of Labor customer contract, which is
being amortized over the remaining life on the contract of five
years. The remaining $440,000 of acquired intangible assets was
allocated to proprietary software, which is being amortized over
five years.

Avasta, Inc.On
February 5, 2003, we acquired Avasta, a provider of remote
hosting and managed service operations in an all-stock
transaction valued at approximately $370,000. The acquisition
was made to enhance our ability to be a full service provider of
applications management services and technology to our
customers. The purchase price consisted of 231,039 shares
of common stock at a per share value of $1.60. The purchase
price of $442,000 consists of the issuance of common stock for
approximately $370,000 and approximately $72,000 in acquisition
costs. The Agreement and Plan of Merger provided that up to an
additional 1,004,518 shares of common stock could be issued
in the event certain revenue targets are achieved through June
2003. As a result of the earnout calculation, in September 2003,
we issued 179,353 shares of our common stock at a per share
value of $4.14. During the third quarter of 2004, we finalized
our purchase accounting for this acquisition, which resulted in
the reclassification from leasehold improvements to an
intangible asset allocated to customer lists in the amount of
approximately $1.5 million, which is being amortized over
the remaining four years.

Subsequent to our fiscal 2004 year end, and
pursuant to an arbitration decision (see Note 12(b))
whereby the arbitrator found that we breached our obligations
under the Agreement and Plan of Merger and ordered us to issue
to the former Avasta shareholders, or their designee, an
aggregate of 321,880 shares of our common stock and
reimburse related attorneys fees, costs and disbursements,
we have recorded, as of July 31, 2004, approximately
$2.4 million related to this arbitration decision in
general and administrative expense.

Conxion Corporation.On April 2, 2003, we completed the acquisition of Conxion,
a provider of software distribution services and network/server
security expertise for its customers, pursuant to an Agreement
and Plan of Merger, dated as of March 26, 2003 (Conxion
Agreement), by and between us, Union Acquisition Corp., a
Delaware corporation and our wholly-owned subsidiary and
Conxion. Pursuant to the Conxion Agreement, the shareholders of
Conxion received an aggregate of $1.9 million in cash. The
acquisition was made to enhance our ability to be a full service
provider of applications management services and technology to
our customers. The source of funds used for the acquisition of
Conxion was our cash on hand. The acquisition price was based on
the parties determination of the fair value of Conxion and
the terms

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

of the Conxion Agreement were derived from
arms-length negotiation among the parties. The purchase price of
$2.0 million consisted of the $1.9 million paid to the
Conxion shareholders and approximately $106,000 in acquisition
costs. The negative goodwill of approximately $2.2 million
reduced the recorded basis of property and equipment. This
acquisition was accounted for using the purchase method of
accounting.

Interliant.On
May 16, 2003, we completed the acquisition of substantially
all of the assets relating to the managed infrastructure
solutions business, encompassing messaging and collaboration,
managed hosting, bundled-in managed security, and integrated and
related professional services in the United States and in Europe
of Interliant, Inc., a Delaware corporation, and several of its
subsidiaries (Debtors) in the bankruptcy proceedings of the
Debtors under Chapter 11 of Title 11 of the United
States Bankruptcy Code pending in the Southern District of New
York (White Plains), pursuant to an Asset Purchase Agreement,
dated as of May 15, 2003 (the Agreement), by and between
our subsidiary, Intrepid Acquisition Corp. and the Debtors,
approved by order of the Bankruptcy Court on May 15, 2003.
Pursuant to the Agreement, the aggregate purchase price for the
Interliant assets, excluding certain assumed liabilities, was
approximately $7.2 million after adjustments, based upon
the Debtors adjusted net worth, comprised of approximately
$5.8 million in cash, $0.6 million in the form of a
credit of future distributions to be paid on the Interliant
Notes, $0.6 million in principal amount of a non-interest
bearing, 180-day promissory note, secured by the Interliant
Notes and the accounts receivable acquired as part of the
Interliant Assets and approximately $0.2 million in
acquisition-related costs. On May 16, 2003, we closed on
the purchase of all of the Interliant Assets, other than the
Debtors accounts receivable. On June 6, 2003, we
closed on the purchase of the accounts receivable. The source of
funds used for the initial closing was our cash on hand combined
with the funds provided from and through financing of our
accounts receivable with Silicon Valley Bank (SVB), as discussed
below, cash acquired with the Interliant assets, and cash
receipts from the purchased accounts receivable. The acquisition
price was determined through arms-length negotiations and
competitive bidding for the Interliant Assets at an auction
conducted under the auspices of the Bankruptcy Court. On
March 8, 2004, the court approved an approximate
$0.3 million net worth adjustment in favor of Intrepid and
we adjusted our purchase accounting to reflect this resolution.
In conjunction with this resolution, Intrepids approximate
$0.6 million promissory note in favor of Interliant was
satisfied out of the net worth adjustment and the remaining
balance of $0.2 million was paid from funds Intrepid had
placed in escrow (see Note 11). The acquisition was
accounted for under the purchase method of accounting.

ClearBlue
Technologies.On August 8, 2003,
we completed the acquisition of certain assets and the
assumption of certain liabilities of CBT pursuant to a Stock and
Asset Acquisition Agreement (the CBT Agreement).
Pursuant to the CBT Agreement, we acquired all outstanding
shares of six (6) wholly owned subsidiaries of CBT with
data centers located in Chicago, Las Vegas, Los Angeles,
Milwaukee, Oakbrook and Vienna.

In addition, we assumed the revenue and expense,
as of the date of the CBT Agreement, of four (4) additional
wholly owned subsidiaries of CBT with data centers located in
Dallas, New York, San Francisco and Santa Clara.
Ownership of these subsidiaries was to be automatically
transferred, under certain conditions, to us for no additional
consideration in February 2004. On February 6, 2004, we
entered into an amendment (as discussed in Note 2) to
extend the date by which we are able to cause the transfer of
these CBT wholly owned subsidiaries to us from February 8,
2004 to on or prior to August 8, 2005, under certain
conditions and for no additional consideration. In consideration
for such amendment, we agreed to operate and manage these
entities in a manner consistent with the CBT Agreement.

In exchange for these subsidiaries and certain
assets and contracts relating to them, we: (i) issued
1.1 million shares of our common stock, to CBT;
(ii) released CBT from certain inter-company advances in an
amount up to $300,000; (iii) assumed all of CBTs
obligations under certain assets and contracts relating to these
subsidiaries; and (iv) released CBT from certain payment
obligations owed to us pursuant to the Outsourcing Agreement in
an amount not to exceed $263,000.

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

As Atlantic Investors, LLC had a controlling
interest in both NaviSite and CBT at the time of the CBT
Agreement, the transaction was accounted for as a combination of
entities under common control (i.e., as if pooling)
whereby the assets and liabilities of CBT and NaviSite were
combined at their historical amounts. Accordingly, the
Companys consolidated financial statements have been
restated for all periods prior to the business combination to
include CBTs financial results beginning on
September 11, 2002, the date on which CBT acquired the
controlling interest in the Company.

On April 14, 2004, pursuant to the
Amendment, NaviSite exercised its right to acquire from CBT all
of the outstanding shares of the Deferred Entities, for no
additional consideration.

Surebridge.On
June 10, 2004, we completed the acquisition of
substantially all of the assets and liabilities of Surebridge,
Inc., or Surebridge, a privately held provider of managed
application services for mid-market companies, in exchange for
two promissory notes (see Note 11) in the aggregate
principal amount of approximately $39.3 million, three
million shares of our common stock and the assumption of certain
liabilities of Surebridge at closing. The primary reasons for
the acquisition included the addition of service offerings,
specific contractual relationships with PeopleSoft and
Microsoft, and established contractual revenue base, as well as
potential operational savings. As the primary reasons for the
acquisition were not related to the tangible net assets of
Surebridge, the purchase price was significantly in excess of
the fair value of the net assets acquired. The acquisition was
accounted for under the purchase method of accounting. The final
purchase accounting is subject to final resolution of the net
worth calculation. We have included the financial results of
Surebridge in our consolidated financial statements beginning
June 10, 2004, the date of acquisition.

The following table summarizes the fair value of
the assets acquired and liabilities assumed at the date of
acquisition:

|                                      |  |                |        | 
|------------------------------------- |  | -------------- | ------ | 
|                                      |  | Surebridge    
|                                      |  |               
|                                      |  | (In thousands)
|Accounts receivable                   |  | $              | 5,201  | 
|Other current assets                  |  |                | 1,745  | 
|Long-term assets                      |  |                | 560    | 
|Property and equipment                |  |                | 5,725  | 
|Goodwill                              |  |                | 42,714 | 
|Customer lists                        |  |                | 14,000 | 
|                                      |  |                |        | 
|Total assets acquired                 |  |                | 69,945 | 
|                                      |  |                |        | 
|Accounts payable and accrued expenses |  |                | 9,030  | 
|Other current liabilities             |  |                | 6,496  | 
|Long-term liabilities                 |  |                | 1,002  | 
|                                      |  |                |        | 
|Total liabilities assumed             |  |                | 16,528 | 
|                                      |  |                |        | 
|Net assets acquired                   |  | $              | 53,417 | 
|                                      |  |                |        | 

F-23



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The following unaudited pro forma results for the
years ended July 31, 2004, 2003 and 2002 give effect to our
2004 acquisition of Surebridge as if it had taken place at the
beginning of fiscal year 2003 and our 2003 acquisitions of
Avasta, Conxion, Interliant and common control mergers of CBTM
and CBT as if they had taken place at the beginning of fiscal
year 2002. The pro forma information does not necessarily
reflect the results of operations that would have occurred had
the acquisitions taken place at the beginning of the fiscal
periods indicated and is not necessarily indicative of results
that may be obtained in the future:

|                   |  |                           |         |      |  |      |         |   |  |   |          |  
|------------------ |  | ------------------------- | ------- | ---- |  | ---- | ------- | - |  | - | -------- | -
|                   |  |                          
|                   |  | Year Ended July 31,      
|                   |  |                          
|                   |  | 2004                      |         | 2003 |  | 2002
|                   |  |                           |         |      |  |     
|                   |  |                          
|                   |  | Pro Forma (Unaudited)    
|                   |  |                          
|                   |  |                          
|                   |  | (In thousands, except for
|                   |  | per share amounts)       
|Revenue            |  | $                         | 129,764 |      |  | $    | 147,802 |   |  | $ | 197,726  |  
|Net loss           |  | $                         | (27,481 | )    |  | $    | (98,520 | ) |  | $ | (286,962 | )
|Net loss per share |  | $                         | (0.99   | )    |  | $    | (6.72   | ) |  | $ | (52.59   | )

(9) Investment in Debt
Securities

In a privately negotiated transaction with Fir
Tree Recovery Master Fund, LP and Fir Tree Value Partners, LDC,
pursuant to an Assignment Agreement dated October 11, 2002
and in a series of open market transactions from certain other
third-party holders, we acquired an aggregate principal amount
of approximately $36.3 million face value,
10% convertible senior notes (Interliant Notes) due in 2006
of Interliant, Inc. (Interliant) for a total consideration of
approximately $2.0 million. Interliant was a provider of
managed services, which filed a petition under Chapter 11
of Title 11 of the United States Bankruptcy Code in the
Southern District of New York (White Plains) on August 5,
2002, and we made this investment with the intention of
participating in the reorganization/sale of Interliant.

On May 16, 2003, the Bankruptcy Court
confirmed us as the successful bidder for the purchase of the
Interliant Assets (see Note 8). We used $624,000 of the
first projected distributions to be made on our Interliant Notes
as partial payment for the assets acquired. As such, we have
reduced the carrying value of the Interliant Notes by this
amount. On September 30, 2004, the Third Amended Plan of
Liquidation of Interliant and its affiliated debtors became
effective. The final amount and timing of distributions we will
receive on our Interliant Notes has not been determined. It may
be greater or less than the remaining carrying value, however,
we have estimated the value to approximate the $1.4 million
carrying value included in other assets on our Consolidated
Balance Sheet.

(10) Accrued Expenses

Accrued expenses consist of the following:

|                                          |  |                |        |      |  |   |        | 
|----------------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | 
|                                          |  |               
|                                          |  | July 31,      
|                                          |  |               
|                                          |  | 2004           |        | 2003
|                                          |  |                |        |     
|                                          |  |               
|                                          |  | (In thousands)
|Accrued payroll, benefits and commissions |  | $              | 6,580  |      |  | $ | 3,088  | 
|Accrued legal                             |  |                | 3,098  |      |  |   | 551    | 
|Accrued accounts payable                  |  |                | 2,727  |      |  |   | 3,694  | 
|Due to AppliedTheory Estate               |  |                | 1,464  |      |  |   | 1,461  | 
|Accrued interest                          |  |                | 659    |      |  |   | 351    | 
|Accrued contract termination fees         |  |                | 984    |      |  |   | 2,096  | 
|Accrued other                             |  |                | 3,378  |      |  |   | 3,803  | 
|                                          |  |                |        |      |  |   |        | 
|                                          |  | $              | 18,890 |      |  | $ | 15,044 | 
|                                          |  |                |        |      |  |   |        | 

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

(11) Debt

Debt consists of the following:

|                                        |  |          |        |      |  |   |        | 
|--------------------------------------- |  | -------- | ------ | ---- |  | - | ------ | 
|                                        |  |         
|                                        |  | July 31,
|                                        |  |         
|                                        |  | 2004     |        | 2003
|                                        |  |          |        |     
|Accounts receivable financing line, net |  | $        | 20,240 |      |  | $ | 6,358  | 
|Notes payable to Atlantic Investors     |  |          | 3,000  |      |  |   | 3,000  | 
|Note to the AppliedTheory Estate        |  |          | 6,000  |      |  |   | 6,000  | 
|Notes payable to landlord               |  |          | 1,908  |      |  |   |       | 
|Convertible notes payable to Surebridge |  |          | 39,267 |      |  |   |       | 
|Notes payable to the Interliant Estate  |  |          |       |      |  |   | 550    | 
|Other notes payable                     |  |          |       |      |  |   | 661    | 
|                                        |  |          |        |      |  |   |        | 
|Total                                   |  | $        | 70,415 |      |  | $ | 16,569 | 
|                                        |  |          |        |      |  |   |        | 
|Less current portion                    |  |          | 24,791 |      |  |   | 10,569 | 
|                                        |  |          |        |      |  |   |        | 
|Long-term debt                          |  |          | 45,624 |      |  |   | 6,000  | 
|                                        |  |          |        |      |  |   |        | 

(a) Silicon
Valley Bank Financing Arrangements

On May 27, 2003, we entered into an Accounts
Receivable Financing Agreement (Financing Agreement), by and
among Silicon Valley Bank (SVB), us and our wholly owned
subsidiaries, ClearBlue Technologies Management, Inc., Avasta,
Inc., Conxion Corporation and Intrepid Acquisition Corp.,
whereby we can finance up to a maximum of $12.5 million of
our eligible accounts receivables with an 80% advance rate.
Under the Financing Agreement, we are required to repay advances
upon the earlier of our receipt of payment on the financed
accounts receivables from our customers, or the financed
accounts receivable being aged greater than ninety days from
date of service. The Financing Agreement has a one-year term and
bears an annual interest rate of prime rate plus 4.0%, with a
minimum $10,000 monthly finance charge. The Financing
Agreement also contains certain affirmative and negative
covenants and is secured by substantially all of our assets,
tangible and intangible. As part of the Financing Agreement, on
May 27, 2003 we issued to SVB a warrant to purchase up to
165,000 shares of NaviSite common stock with an exercise
price of $2.50 per share, the closing price of our stock on
the last business day before the issuance of the warrant. We
fair valued the warrants at $370,000 using the Black-Scholes
option-pricing model. The value of the warrants was amortized
into interest expense over the one-year term of the Financing
Agreement. Under the conversion rights of the warrant, on
May 19, 2004, SVB exercised its warrant to
purchase 165,000 shares of our common stock, which
resulted in a net issuance of 73,738 shares.

On January 30, 2004, we entered into a Loan
Modification Agreement with SVB. The agreement amended our
accounts receivable financing agreement with SVB, among other
things, to: (i) base future borrowings on monthly recurring
revenue; (ii) increase the maximum borrowing level from
$10.0 million to $12.8 million; and (iii) extend
the term until January 29, 2006. In connection with this
amended agreement, on January 30, 2004, we issued a warrant
to SVB for the purchase of 50,000 shares of common stock at
an exercise price of $5.75 per share. We fair valued the
warrant at $213,426 using the Black-Scholes option-pricing
model. The value of the warrant is being amortized into interest
expense over the term of the modified Financing Agreement. The
warrant is exercisable at any time on or after September 1,
2004. Pursuant to the terms of a Registration Rights Agreement,
dated as of January 30, 2004, we also granted certain
registration rights to SVB with respect to the shares of common
stock issuable upon exercise of the warrant.

On April 29, 2004, we entered into a Second
Loan Modification Agreement with SVB. The agreement amended our
account receivable financing agreement, with SVB to, among other
things: (i) increase our

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

maximum borrowing level from $12.8 million
to $20.4 million; and (ii) extend the term until
April 29, 2006. On July 31, 2004, we had an
outstanding balance under the amended agreement of
$20.4 million.

Under the amended agreement, borrowings are based
on monthly recurring revenue. We are required to prepare and
deliver a written request for an advance of up to three times
the value of total recurring monthly revenue, calculated to be
monthly revenue (including revenue from The New York State
Department of Labor) less professional services revenue. SVB may
then provide an advance of 85% of such value (or such other
percentage as the bank may determine). The interest rate under
the amended agreement is variable and is currently calculated at
the banks published prime rate plus 4.0%.
Following the completion of certain equity or debt financings,
and provided we continue to meet certain ratios under the
amended agreement, the interest rate shall be reduced to the
banks prime rate plus 1.0%. In no event, however, will the
banks prime rate be less than 4.25%. The accounts
receivable financing line at July 31, 2004 and 2003 is
reported net of the remaining value ascribed to the related
warrants of $0.2 million and $0.3 million,
respectively.

(b) Note
Payable to Atlantic Investors, LLC (Atlantic)

On January 29, 2003, we entered into a
$10.0 million Loan and Security Agreement (Atlantic Loan)
with Atlantic, a related party. The Atlantic Loan bears an
interest rate of 8% per annum. Interest is payable upon
demand or, at Atlantics option, interest may be added to
the outstanding balance due to Atlantic by NaviSite. Atlantic
may make demand for payment of amounts in excess of the minimum
Atlantic Loan amount of $2.0 million (Minimum
Loan Amount), with 60 days notice. Atlantic can demand
payment of the Minimum Loan Amount with 90 days
notice. Under the Atlantic Loan agreement, we can require
Atlantic to loan us (1) up to $2.0 million to repay an
amount due from CBTM to Unicorn, a related party to NaviSite and
Atlantic; (2) $1.0 million for costs associated with
our acquisition of Avasta; and (3) up to $500,000 for the
post-acquisition working capital needs of Avasta. Atlantic, at
its sole and absolute discretion, may advance other amounts to
us such that the aggregate amount borrowed by NaviSite does not
exceed the maximum loan amount, defined as the lesser of
$10.0 million or 65% of our consolidated accounts
receivables. On May 30, 2003, we repaid $2.0 million
of the approximate $3.0 million outstanding under the
Atlantic Loan and on June 11, 2003, we borrowed
$2.0 million under the Atlantic Loan. At July 31,
2004, we had $3.0 million outstanding under the Atlantic
Loan. This amount is shown as Note payable to related party on
our Consolidated Balance Sheet. The Atlantic Loan is secured by
all of our receivables and is subordinated to the borrowings
from Silicon Valley Bank.

On January 16, 2004, the Atlantic Loan was
amended to extend any and all Credit Advances under the Atlantic
Loan made prior to, or following, January 16, 2004, to be
due on or before the earlier of (i) August 1, 2004 or
(ii) five (5) business days following the closing of a
financing transaction or disposition pursuant to which the
Borrower receives gross proceeds of $13.0 million. On
July 13, 2004, the Atlantic Loan was amended to extend any
and all Credit Advances under the Atlantic Loan made prior to,
or following, July 13, 2004, to be due on or before the
earlier of (i) November 1, 2004 or (ii) five
(5) business days following the closing of a financing
transaction or disposition pursuant to which the Borrower
receives net proceeds of $13.0 million after satisfying the
mandatory prepayment obligation under those certain Notes due to
Surebridge, Inc. On October 12, 2004, the Atlantic Loan was
amended to extend any and all Credit Advances under the Atlantic
Loan made prior to, or following, October 12, 2004, to be
due on or before the earlier of (i) February 1, 2005
or (ii) five (5) business days following the closing
of a financing transaction or disposition pursuant to which the
Borrower receives net proceeds of $13.0 million after
satisfying the mandatory prepayment obligation under those
certain Notes due to Surebridge, Inc.

(c) Note
Payable to the AppliedTheory Estate

As part of CBTMs acquisition of certain
AppliedTheory assets, CBTM entered into two unsecured promissory
notes totaling $6.0 million (Estate Liability) due to the
AppliedTheory Estate on June 10, 2006. The Estate Liability
bears interest at 8% per annum, which is due and payable
annually. At July 31, 2004, we

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NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

had approximately $80,000 in accrued interest
related to this note, which is reflected within accrued expenses
on our Consolidated Balance Sheet.

(d) Notes
Payable to the Interliant Estate

As part of our acquisition of certain Interliant
Assets, we entered into a promissory note with the Interliant
Estate (Interliant Promissory Note) in the amount of $550,000,
payable without interest on the earlier of (i) the 180th
day following the Second Closing Date or (ii) the date
Interliant Estate makes distributions to their general unsecured
creditors. The Interliant Promissory Note was secured by the
Interliant Notes. Pursuant to the terms of the Asset Purchase
Agreement between Intrepid and Interliant, each party placed
$300,000 in escrow as security for adjustments in the purchase
price based upon changes in Interliants net worth at the
time of the closing. On March 8, 2004, the court approved
the $325,000 net worth adjustment in favor of Intrepid and
we adjusted our purchase accounting to reflect this resolution
by reducing intangible assets. In conjunction with this
resolution, Intrepids $550,000 promissory note in favor of
Interliant was satisfied out of the net worth adjustment and the
remaining balance of $225,000 was paid from funds Intrepid had
placed in escrow (see Note 8).

(e) Notes
Payable to Landlord

As part of an amendment to our 400 Minuteman Road
lease, $2.2 million of our future payments to the landlord
of our 400 Minuteman Road facility were transferred into a note
payable (Landlord Note). The Landlord Note bears interest at an
annual rate of 11% and calls for 36 equal monthly payments of
principal and interest, with the final payment due on
November 1, 2006. The $2.2 million represents
leasehold improvements made by the landlord, on our behalf, to
the 400 Minuteman location in order to facilitate the leasing of
a portion of the facility (First Lease Amendment), as well as
common area maintenance and property taxes associated with the
space.

In addition, during fiscal year 2004, we paid
$120,000 and we entered into a separate $150,000 note (Second
Landlord Note) with the landlord for additional leasehold
improvements to facilitate a subleasing transaction involving a
specific section of the 400 Minuteman location. The Second
Landlord Note bears interest at an annual rate of 11% and calls
for 36 equal monthly payments of principal and interest, with
the final payment due on March 1, 2007.

(f) Notes
Payable to Surebridge

On June 10, 2004, in connection with our
acquisition of the Surebridge business, we issued two
convertible promissory notes in the aggregate principal amount
of approximately $39.3 million. Interest shall accrue on
the unpaid balance of the notes at the annual rate of 10%,
provided that if an event of default shall occur and be
continuing, the interest rate shall be 15%. Notwithstanding the
foregoing, no interest shall accrue or be payable on any
principal amounts repaid on or prior to the nine-month
anniversary of the issuance date of the notes. We must repay the
outstanding principal of the notes with all interest accrued
thereon, no later than June 10, 2006. In addition, if at
any time during the first six months after the date of issuance
of the notes we complete certain equity or debt financings,
including our proposed public offering, we are obligated to use
a significant portion of the proceeds to make payments on the
notes, depending on the total net proceeds received by us in the
financing. If we receive net proceeds of less than
$20.0 million in a debt or equity financing, then we would
be obligated to make a payment on the notes equal to 75% of the
net proceeds. If we receive net proceeds of between
$20.0 million and $30.0 million, then we would be
obligated to make a payment on the notes equal to
$15.0 million. If we receive net proceeds in excess of
$30.0 million, then we would be obligated to make a payment
on the notes equal to 50% of the net proceeds. Pursuant to the
terms of the acquisition agreement, $0.8 million of the
primary note is callable at anytime for a period of one year
from June 10, 2004, the date of closing, and is included in
Notes payable, current portion on our July 31, 2004
Consolidated Balance Sheet.

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

In addition, if we realize net proceeds in excess
of $1.0 million from certain equity or debt financings or
sales of assets at any time after six months from the date the
notes were issued, we are obligated to use a significant portion
of the proceeds to make payments on the notes, depending on the
total payments, if any, made on the notes during the first six
months after the notes were issued. If the amount we paid on the
notes during the first six months the notes were outstanding is
less than $10.0 million, we would be obligated to make a
payment on the notes equal to 75% of the net proceeds. If the
amount we paid on the notes during the first six months the
notes were outstanding was greater than $15.0 million, we
would be obligated to make a payment on the notes equal to 50%
of the net proceeds. If the amount we paid on the notes during
the first six months the notes were outstanding is between
$10.0 million and $15.0 million, we would be obligated
to make a payment on the notes equal to a percentage between 50%
and 75% of the net proceeds received in the financing calculated
in accordance with a formula set forth in the notes.

It shall be deemed an event of default under the
notes if, among other things, we fail to pay when due any
amounts under the notes, if we fail to pay when due or
experience an event of default with respect to any debts having
an outstanding principal amount of $500,000 or more, if we are
delisted from the Nasdaq SmallCap Market, or if we are acquired
and the acquiring party does not expressly agree to assume the
notes. In addition, certain bankruptcy, reorganization,
insolvency, dissolution and receivership actions would be deemed
an event of default under the notes. If an event of default
under the notes occurs, the holder shall be entitled to declare
the notes immediately due and payable in full.

The notes provide that we shall not incur any
indebtedness in excess of $20.5 million in the aggregate,
unless such indebtedness is unsecured and expressly subordinated
to the notes, is otherwise permitted under the notes, or the
proceeds are used to make payments on the notes.

Finally, the outstanding principal of and accrued
interest on the notes are convertible into shares of NaviSite
common stock at a conversion price of $4.642 at the election of
the holder:



| |   |                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | at any time following the first anniversary of
    the closing if the aggregate principal outstanding under the
    notes at such time is greater than or equal to
    $20.0 million;   
|
| |  | at any time following the 18-month anniversary of
    the closing if the aggregate principal outstanding under the
    notes at such time is greater than or equal to
    $10.0 million;
|
| |  | at any time following the second anniversary of
    the closing; and                                                                                                                    
|
| |  | at any time following an event of default
    thereunder.                                                                                                                               



|     |                              
|---- | -----------------------------
|(12) | Commitments and Contingencies



|    |       
|--- | ------
|(a) | Leases

Abandoned Leased FacilitiesDuring fiscal year 2003, we abandoned
our administrative space on the second floor of our 400
Minuteman Road, Andover, MA leased location. We continue to
maintain and operate our Data Center on the first floor of the
building. While we remain obligated under the terms of the lease
for the rent and other costs associated with the second floor of
the building, we ceased to use the space on January 31,
2003. Therefore, in accordance with SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal
Activities, issued in July 2002, we recorded a charge to
our earnings in fiscal year 2003 of approximately
$5.4 million to recognize the costs of exiting the space.
The liability is equal to the total amount of rent and other
direct costs for the period of time the second floor of the
building was expected to remain unoccupied plus the present
value of the amount by which the rent paid by us to the landlord
exceeds any rent paid to us by a tenant under the terms of a
sublease over the remainder of the initial lease term, which is
January 2012. During fiscal year 2004 we amended our existing
agreement with the landlord of our 400 Minuteman Road
facility. As a result of the amendment $2.2 million of our
future payments to the landlord were transferred into a note
payable (see Note 11). Additionally we incurred charges
totaling approximately $0.7 million related primarily to
changes in common area maintenance, property taxes and other
estimates in our initial calculation.

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NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Near the end of our fiscal year 2002, we
abandoned our sales office space in La Jolla, CA. At that
time we were able to sublet the space to a third party. During
the second quarter of fiscal year 2003, the sublease tenant
stopped making payments under the sublease and has abandoned the
space. The facility is currently empty and we remain obligated
under the terms of the lease for the rent and other costs
associated with the building. We have no foreseeable plans to
occupy the space; therefore, in accordance with
SFAS No. 146, we recorded a charge to our earnings of
approximately $1.4 million during fiscal year 2003 to
recognize the costs of exiting the building.

During the third quarter of fiscal year 2003, in
conjunction with the Conxion acquisition, we impaired data
center and office leases in Chicago, IL, Herndon, VA, and
Amsterdam, as these leases provided no economic benefit to the
combined company.

During the first quarter of fiscal year 2004, we
abandoned administrative office space at 55 Francisco St.,
San Francisco, CA and data center space and office space
located at Westwood Center, Vienna, VA. While we remain
obligated under the terms of these leases for the rent and other
costs associated with these leases, we made the decision to
cease using these spaces on October 31, 2003 and have no
foreseeable plans to occupy them in the future. Therefore, in
accordance with SFAS No. 146, we recorded a charge to
our current earnings in the first quarter of fiscal year 2004 of
approximately $1.1 million to recognize the costs of
exiting the space. The liability is equal to the total amount of
rent and other direct costs for the period of time space is
expected to remain unoccupied plus the present value of the
amount by which the rent paid by us to the landlord exceeds any
rent paid to us by a tenant under a sublease over the remainder
of the lease terms, which expire in January 2006 for
San Francisco, CA and July 2005 for Vienna, VA.

During the third quarter of fiscal year 2004, we
recorded a $206,000 net impairment charge resulting from
the write-off of $300,000 in property and equipment, net of
$94,000 in recovery of impairment charges, triggered by the
termination and settlement of the abandoned lease at 55
Francisco, San Francisco, CA. Additional net adjustments of
$69,000 were during the third quarter of fiscal year 2004 in
conjunction with the final purchase accounting for Conxion.

During the fourth quarter of fiscal year 2004, we
abandoned administrative office spaces in Houston, TX,
San Jose, CA and Syracuse, NY. While we remain obligated
under the terms of these leases for the rent and other costs
associated with these leases, we made the decision to cease
using these spaces during the fourth quarter of fiscal year 2004
and have no foreseeable plans to occupy them in the future.
Therefore, in accordance with SFAS No. 146, we
recorded a charge to our current earnings in the fourth quarter
of fiscal year 2004 of approximately $2.7 million to
recognize the costs of exiting these spaces. The liability is
equal to the total amount of rent and other direct costs for the
period of time the spaces are expected to remain unoccupied plus
the present value of the amount by which the rent paid by us to
the landlord exceeds any rent paid to us by a tenant under a
sublease over the remainder of the lease terms, which expire in
October 2008 for Houston, TX, November 2006 for San Jose,
CA and December 2007 for Syracuse, NY.

During the fourth quarter of fiscal year 2004, we
recorded a $284,000 net impairment charge to cost of
revenue triggered by a change in the expected recovery from a
sublease arrangement at the abandoned lease in Vienna, VA.

Additionally, the Company recorded a
$0.4 million net impairment charge related to its LaJolla,
CA and Amsterdam facilities during the fourth quarter of fiscal
year 2004. This net charge is primarily due to changes in
sublease assumptions for the LaJolla space and the impact of a
favorable settlement agreement for the Amsterdam lease.

Also during the fourth quarter of fiscal year
2004, in conjunction with the Surebridge acquisition, we
impaired administrative space in office leases in Bedford, NH
and two leases in Atlanta, GA as these spaces provided no
economic benefit to the combined company.

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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

All impairment expense amounts recorded are
included in the caption Impairment, restructuring and
other in the accompanying Consolidated Statements of
Operations.

Details of activity in the lease exit accrual for
the year ended July 31, 2003 were as follows:

|                             |  |            |   |         |  |            |       |             |  |                |   |            |  |   |       |     |  |   |        |   |  |   |       | 
|---------------------------- |  | ---------- | - | ------- |  | ---------- | ----- | ----------- |  | -------------- | - | ---------- |  | - | ----- | --- |  | - | ------ | - |  | - | ----- | 
|                             |  | Balance at |   |         |  |            |       | Purchase    |  | Payments, Less |   | Balance at
|                             |  | July 31,   |   |         |  | Transfers/ |       | Accounting  |  | Accretion of   |   | July 31,  
|Lease Abandonment Costs for: |  | 2002       |   | Expense |  | Reclasses  |       | Adjustments |  | Interest       |   | 2003      
|                             |  |            |   |         |  |            |       |             |  |                |   |           
|400 Minuteman                |  | $          |  |         |  | $          | 5,409 |             |  | $              |  |            |  | $ |      |     |  | $ | (2,069 | ) |  | $ | 3,340 | 
|La Jolla, CA                 |  |            |  |         |  |            | 1,431 |             |  |                |  |            |  |   |      |     |  |   | (322   | ) |  |   | 1,109 | 
|Chicago, IL                  |  |            |  |         |  |            |      |             |  |                |  |            |  |   | 1,332 | (a) |  |   | (240   | ) |  |   | 1,092 | 
|Herndon, VA                  |  |            |  |         |  |            |      |             |  |                |  |            |  |   | 368   | (a) |  |   | (61    | ) |  |   | 307   | 
|Amsterdam                    |  |            |  |         |  |            |      |             |  |                |  |            |  |   | 164   | (a) |  |   |       |   |  |   | 164   | 
|                             |  |            |   |         |  |            |       |             |  |                |   |            |  |   |       |     |  |   |        |   |  |   |       | 
|                             |  | $          |  |         |  | $          | 6,840 | (b)         |  | $              |  |            |  | $ | 1,864 |     |  | $ | (2,692 | ) |  | $ | 6,012 | 
|                             |  |            |   |         |  |            |       |             |  |                |   |            |  |   |       |     |  |   |        |   |  |   |       | 

Details of activity in the lease exit accrual for
the year ended July 31, 2004 were as follows:

|                             |  |            |       |         |  |            |       |             |  |                |        |            |  |   |     |      |  |   |        |   |  |   |       | 
|---------------------------- |  | ---------- | ----- | ------- |  | ---------- | ----- | ----------- |  | -------------- | ------ | ---------- |  | - | --- | ---- |  | - | ------ | - |  | - | ----- | 
|                             |  | Balance at |       |         |  |            |       | Purchase    |  | Payments, Less |        | Balance at
|                             |  | July 31,   |       |         |  | Transfers/ |       | Accounting  |  | Accretion of   |        | July 31,  
|Lease Abandonment Costs for: |  | 2003       |       | Expense |  | Reclasses  |       | Adjustments |  | Interest       |        | 2004      
|                             |  |            |       |         |  |            |       |             |  |                |        |           
|400 Minuteman                |  | $          | 3,340 |         |  | $          | 661   |             |  | $              | (2,200 | )(c)       |  | $ |    |      |  | $ | (761   | ) |  | $ | 1,040 | 
|La Jolla, CA                 |  |            | 1,109 |         |  |            | 516   |             |  |                |       |            |  |   |    |      |  |   | (489   | ) |  |   | 1,136 | 
|Chicago, IL                  |  |            | 1,092 |         |  |            |      |             |  |                | (48    | )(d)       |  |   | 100 | (a)  |  |   | (222   | ) |  |   | 922   | 
|Herndon, VA                  |  |            | 307   |         |  |            |      |             |  |                | (67    | )(d)       |  |   | (58 | )(a) |  |   | (182   | ) |  |   |      | 
|Amsterdam                    |  |            | 164   |         |  |            | (130  | )           |  |                | 115    | (d)        |  |   | 27  | (a)  |  |   | (56    | ) |  |   | 120   | 
|Vienna, VA                   |  |            |      |         |  |            | 917   |             |  |                |       |            |  |   |    |      |  |   | (369   | ) |  |   | 548   | 
|San Francisco, CA            |  |            |      |         |  |            | 362   |             |  |                |       |            |  |   |    |      |  |   | (114   | ) |  |   | 248   | 
|Houston, TX                  |  |            |      |         |  |            | 946   |             |  |                |       |            |  |   |    |      |  |   | (41    | ) |  |   | 905   | 
|Syracuse, NY                 |  |            |      |         |  |            | 453   |             |  |                |       |            |  |   |    |      |  |   | (95    | ) |  |   | 358   | 
|Syracuse, NY                 |  |            |      |         |  |            | 132   |             |  |                |       |            |  |   |    |      |  |   | (21    | ) |  |   | 111   | 
|San Jose, CA                 |  |            |      |         |  |            | 1,201 |             |  |                |       |            |  |   |    |      |  |   | (182   | ) |  |   | 1,019 | 
|Atlanta, GA                  |  |            |      |         |  |            |      |             |  |                |       |            |  |   | 247 | (e)  |  |   | (17    | ) |  |   | 230   | 
|Atlanta, GA                  |  |            |      |         |  |            |      |             |  |                |       |            |  |   | 323 | (e)  |  |   | (48    | ) |  |   | 275   | 
|Bedford, NH                  |  |            |      |         |  |            |      |             |  |                |       |            |  |   | 340 | (e)  |  |   | (201   | ) |  |   | 139   | 
|                             |  |            |       |         |  |            |       |             |  |                |        |            |  |   |     |      |  |   |        |   |  |   |       | 
|                             |  | $          | 6,012 |         |  | $          | 5,058 | (f)         |  | $              | (2,200 | )          |  | $ | 979 |      |  | $ | (2,798 | ) |  | $ | 7,051 | 
|                             |  |            |       |         |  |            |       |             |  |                |        |            |  |   |     |      |  |   |        |   |  |   |       | 



---



|    |  |                                                                                                                                                                                                                                                     
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | Recorded in purchase accounting for the
    acquisition of Conxion Corporation                                                                                                                                                                      
|   
|(b) |  | Impairment, restructuring and other totaled
    $8.9 million for fiscal year 2003, consisting of
    $6.8 million related to the abandonment of leased
    facilities and $2.1 million related to the impairment
    long-lived assets (see Note 4).
|   
|(c) |  | Transfer of future payments to landlord into a
    note payable (see Note 11)                                                                                                                                                                       
|   
|(d) |  | Reclassifications made between the Conxion
    accrued lease abandonments                                                                                                                                                                           
|   
|(e) |  | Recorded in purchase accounting for the
    acquisition of Surebridge                                                                                                                                                                               
|   
|(f) |  | Impairment, restructuring and other totaled
    $6.2 million for fiscal year 2004, consisting of
    $5.1 million related to the abandonment of leased
    facilities and $1.1 million related to the impairment
    long-lived assets (see Note 4).

F-30



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Minimum annual rental commitments under operating
leases and other commitments are as follows as of July 31,
2004:

|                                  |  |                |         |           |  |        |        |        |  |        |        |        |  |        |        |  |  |   |       |  |  |   |       |  |  |   |        | 
|--------------------------------- |  | -------------- | ------- | --------- |  | ------ | ------ | ------ |  | ------ | ------ | ------ |  | ------ | ------ |  |  | - | ----- |  |  | - | ----- |  |  | - | ------ | 
|                                  |  |                |         | Less than |  |        |        |        |  |        |        |        |  | After 
|Description                       |  | Total          |         | 1 Year    |  | Year 2 |        | Year 3 |  | Year 4 |        | Year 5 |  | Year 5
|                                  |  |                |         |           |  |        |        |        |  |        |        |        |  |       
|                                  |  |               
|                                  |  | (In thousands)
|Short/Long-term debt              |  | $              | 70,575  |           |  | $      | 24,951 |        |  | $      | 45,305 |        |  | $      | 319    |  |  | $ |      |  |  | $ |      |  |  | $ |       | 
|Interest on debt(a)               |  |                | 9,591   |           |  |        | 1,164  |        |  |        | 8,419  |        |  |        | 8      |  |  |   |      |  |  |   |      |  |  |   |       | 
|Capital leases                    |  |                | 3,551   |           |  |        | 1,845  |        |  |        | 1,482  |        |  |        | 224    |  |  |   |      |  |  |   |      |  |  |   |       | 
|Operating leases                  |  |                | 629     |           |  |        | 558    |        |  |        | 47     |        |  |        | 24     |  |  |   |      |  |  |   |      |  |  |   |       | 
|Minimum bandwidth commitments     |  |                | 7,821   |           |  |        | 3,781  |        |  |        | 2,569  |        |  |        | 1,267  |  |  |   | 204   |  |  |   |      |  |  |   |       | 
|Maintenance for hardware/software |  |                | 1,051   |           |  |        | 731    |        |  |        | 160    |        |  |        | 160    |  |  |   |      |  |  |   |      |  |  |   |       | 
|Property leases(b)                |  |                | 63,880  |           |  |        | 13,528 |        |  |        | 11,903 |        |  |        | 9,520  |  |  |   | 8,225 |  |  |   | 6,072 |  |  |   | 14,632 | 
|                                  |  |                |         |           |  |        |        |        |  |        |        |        |  |        |        |  |  |   |       |  |  |   |       |  |  |   |        | 
|                                  |  | $              | 157,098 |           |  | $      | 46,558 |        |  | $      | 69,885 |        |  | $      | 11,522 |  |  | $ | 8,429 |  |  | $ | 6,072 |  |  | $ | 14,632 | 
|                                  |  |                |         |           |  |        |        |        |  |        |        |        |  |        |        |  |  |   |       |  |  |   |       |  |  |   |        | 



---



|    |                                                                                                                                   
|--- | ----------------------------------------------------------------------------------------------------------------------------------
|(a) | Amounts do not include interest on the accounts
    receivable financing line, as interest rate is variable.                      
|   
|(b) | Amounts exclude certain common area maintenance
    and other property charges that are not included within the
    lease payment.

Total rent expense for property leases was
$10.5 million, $11.6 million and $5.2 million for
fiscal years ended July 31, 2004, 2003 and 2002,
respectively.

With respect to the property lease commitments
listed above, certain cash is restricted pursuant to terms of
lease agreements with landlords. At July 31, 2004, this
restricted cash of $1.8 million on the balance sheet
consisted of certificates of deposit and a treasury note and are
recorded at cost, which approximates fair value.



|    |              
|--- | -------------
|(b) | Legal Matters



| |                          
| | -------------------------
| | IPO Securities Litigation

On or about June 13, 2001, Stuart Werman and
Lynn McFarlane filed a lawsuit against us, BancBoston Robertson
Stephens, an underwriter of our initial public offering in
October 1999, Joel B. Rosen, our then chief executive
officer, and Kenneth W. Hale, our then chief financial officer.
The suit was filed in the United States District Court for the
Southern District of New York. The suit generally alleges that
the defendants violated federal securities laws by not
disclosing certain actions allegedly taken by Robertson Stephens
in connection with our initial public offering. The suit alleges
specifically that Robertson Stephens, in exchange for the
allocation to its customers of shares of our common stock sold
in our initial public offering, solicited and received from its
customers agreements to purchase additional shares of our
common stock in the aftermarket at pre-determined prices. The
suit seeks unspecified monetary damages and certification of a
plaintiff class consisting of all persons who acquired shares of
our common stock between October 22, 1999 and
December 6, 2000. Three other substantially similar
lawsuits were filed between June 15, 2001 and July 10,
2001 by Moses Mayer (filed June 15, 2001), Barry Feldman
(filed June 19, 2001), and Binh Nguyen (filed July 10,
2001). Robert E. Eisenberg, our president at the time of
the initial public offering in 1999, also was named as a
defendant in the Nguyen lawsuit.

On or about June 21, 2001, David Federico
filed in the United States District Court for the Southern
District of New York a lawsuit against us, Mr. Rosen,
Mr. Hale, Robertson Stephens and other underwriter
defendants including J.P. Morgan Chase, First Albany
Companies, Inc., Bank of America Securities, LLC, Bear
Stearns & Co., Inc., B.T. Alex. Brown, Inc., Chase
Securities, Inc., CIBC World Markets, Credit Suisse First Boston
Corp., Dain Rauscher, Inc., Deutsche Bank Securities, Inc., The
Goldman Sachs Group, Inc., J.P. Morgan & Co.,
J.P. Morgan Securities, Lehman Brothers, Inc., Merrill
Lynch, Pierce, Fenner & Smith,

F-31



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Inc., Morgan Stanley Dean Witter & Co.,
Robert Fleming, Inc. and Salomon Smith Barney, Inc. The suit
generally alleges that the defendants violated the anti-trust
laws and the federal securities laws by conspiring and agreeing
to raise and increase the compensation received by the
underwriter defendants by requiring those who received
allocation of initial public offering stock to agree to purchase
shares of manipulated securities in the after-market of the
initial public offering at escalating price levels designed to
inflate the price of the manipulated stock, thus artificially
creating an appearance of demand and high prices for that stock,
and initial public offering stock in general, leading to further
stock offerings. The suit also alleges that the defendants
arranged for the underwriter defendants to receive undisclosed
and excessive brokerage commissions and that, as a consequence,
the underwriter defendants successfully increased investor
interest in the manipulated initial public offering of
securities and increased the underwriter defendants
individual and collective underwritings, compensation, and
revenue. The suit further alleges that the defendants violated
the federal securities laws by issuing and selling securities
pursuant to the initial public offering without disclosing to
investors that the underwriter defendants in the offering,
including the lead underwriters, had solicited and received
excessive and undisclosed commissions from certain investors.
The suit seeks unspecified monetary damages and certification of
a plaintiff class consisting of all persons who acquired shares
of our common stock between October 22, 1999 and
June 12, 2001.

Those five cases, along with lawsuits naming more
than 300 other issuers and over 50 investment banks which have
been sued in substantially similar lawsuits, have been assigned
to the Honorable Shira A. Scheindlin (the Court) for
all pretrial purposes (the IPO Securities
Litigation). On September 6, 2001, the Court entered
an order consolidating the five individual cases involving us
and designating Werman v. NaviSite, Inc., et al.,
Civil Action No. 01-CV-5374 as the lead case. A
consolidated, amended complaint was filed thereafter on
April 19, 2002 (the Class Action
Litigation) on behalf of plaintiffs Arvid Brandstrom and
Tony Tse against underwriter defendants Robertson Stephens (as
successor-in-interest to BancBoston), BancBoston,
J.P. Morgan (as successor-in-interest to
Hambrecht & Quist), Hambrecht & Quist and
First Albany and against us and Messrs. Rosen, Hale and
Eisenberg (collectively, the NaviSite Defendants).
Plaintiffs uniformly allege that all defendants, including the
NaviSite Defendants, violated the federal securities laws (i.e.,
Sections 11 and 15 of the Securities Act,
Sections 10(b) and 20(a) of the Exchange Act and
Rule 10b-5) by issuing and selling our common stock
pursuant to the October 22, 1999, initial public offering,
without disclosing to investors that some of the underwriters of
the offering, including the lead underwriters, had solicited and
received extensive and undisclosed agreements from certain
investors to purchase aftermarket shares at pre-arranged,
escalating prices and also to receive additional commissions
and/or other compensation from those investors. At this time,
plaintiffs have not specified the amount of damages they are
seeking in the Class Action Litigation.

Between July and September 2002, the parties
to the IPO Securities Litigation briefed motions to dismiss
filed by the underwriter defendants and the issuer defendants,
including NaviSite. On November 1, 2002, the Court held
oral argument on the motions to dismiss. The plaintiffs have
since agreed to dismiss the claims against Messrs. Rosen,
Hale and Eisenberg without prejudice, in return for their
agreement to toll any statute of limitations applicable to those
claims. By stipulation entered by the Court on November 18,
2002, Messrs. Rosen, Hale and Eisenberg were dismissed
without prejudice from the Class Action Litigation. On
February 19, 2003, an opinion and order was issued on
defendants motion to dismiss the IPO Securities
Litigation, essentially denying the motions to dismiss of all 55
underwriter defendants and of 185 of the 301 issuer defendants,
including NaviSite.

On June 30, 2003, our Board of Directors
considered and authorized us to negotiate a settlement of the
pending Class Action Litigation substantially consistent
with a memorandum of understanding negotiated among class
plaintiffs, the issuer defendants and the insurers for such
issuer defendants. Among other contingencies, any such
settlement would be subject to approval by the Court. Plaintiffs
filed on June 14, 2004, a motion for preliminary approval
of the Stipulation And Agreement Of Settlement With Defendant
Issuers And Individuals (the Preliminary Approval
Motion). As of August 13, 2004, the Preliminary
Approval

F-32



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Motion has been fully briefed but the Court has
not ruled upon or set a date for oral argument, if any, on the
Preliminary Approval Motion. If completed and then approved by
the Court, the settlement is expected to be covered by our
existing insurance policies and is not expected to have a
material effect on our business, financial condition, results of
operations or cash flows.

We believe that the allegations against us are
without merit and, if the settlement is not finalized, we intend
to vigorously defend against the plaintiffs claims. Due to
the inherent uncertainty of litigation, we are not able to
predict the possible outcome of the suits and their ultimate
effect, if any, on our business, financial condition, results of
operations or cash flows.



| |               
| | --------------
| | Joseph Cloonan

On or about September 27, 2002, we received
a demand for a wage payment of $850,000 from our former
Procurement Director, Joseph Cloonan. We rejected the demand,
alleging that Mr. Cloonans claim is based, among
other things, on a potentially fraudulent contract.
Mr. Cloonan also claimed $40,300 for allegedly unpaid
accrued vacation and bonuses and that he may be statutorily
entitled to treble damages and legal fees. On October 11,
2002, NaviSite filed a civil complaint with the Massachusetts
Superior Court, Essex County, seeking a declaratory judgment and
asserting claims against Mr. Cloonan for civil fraud,
misrepresentation, unjust enrichment and breach of duty of
loyalty. Mr. Cloonan asserted counter claims against
NaviSite seeking the payments set forth in his September 2002
demand. The discovery phase of the case has concluded and the
parties may serve dispositive motions through December 2004. We
believe Mr. Cloonans allegations are without merit
and intend to vigorously defend them. Due to the inherent
uncertainty of litigation, we are not able to predict the
possible outcome of this matter and the effect, if any, on our
business, financial condition, results of operations or cash
flows.



| |                         
| | ------------------------
| | Lighthouse International

On October 28, 2002, CBTM, one of our
subsidiaries, filed a complaint in United States District Court
for the Southern District of New York against Lighthouse
International, alleging six causes of action for copyright
infringement, breach of contract, account stated, unjust
enrichment, unfair competition, and misappropriation and/or
conversion. The total claimed damages are in the amount of
$1.9 million. On or about January 16, 2003, Lighthouse
filed and served its answer and counterclaimed against CBTM
claiming $3.1 million in damages and $5.0 million in
punitive relief.

On June 17, 2003, the U.S. Bankruptcy
Court for the Southern District of New York heard oral argument
on Lighthouses Motion for an Order Compelling the Debtor
(AppliedTheory) to Assume or Reject an Agreement, filed in
response to CBTMs complaint, and the objections to
Lighthouses motion filed by CBTM and AppliedTheory.
Lighthouse made this motion on the basis that it never received
notice of CBTM assuming the AppliedTheory contract for the
LighthouseLink Web site. The Bankruptcy Court declined to grant
Lighthouses motion, and instead ordered that an
evidentiary hearing be conducted to determine whether Lighthouse
received appropriate notice of the proposed assignment of the
contract by AppliedTheory to CBTM. The Bankruptcy Court ordered
that the parties first conduct discovery, and upon completion of
discovery, the Bankruptcy Court would schedule an evidentiary
hearing on the issues of due process and notice.

As to the U.S. District Court matter, the
exchange of written discovery and the majority of depositions of
witnesses have been completed. On June 15, 2004, District
Court Judge Pauley determined that both parties could proceed
with their respective summary judgment motions. All motion
papers were to be submitted by September 20, 2004, with
oral argument scheduled for October 15, 2004.

On August 4, 2004, however, upon the
application of CBTM, Bankruptcy Court Judge Gerber preliminarily
enjoined Lighthouse from asserting claims or counterclaims
against CBTM relating to the

F-33



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Lighthouse contract or any assets acquired by
CBTM from AppliedTheory pursuant to the sale order, except for
the purpose and to the extent necessary to setoff claims brought
by CBTM against Lighthouse relating to the Lighthouse contract.
As a result, Lighthouse is limited to seeking only those pre-
and post-bankruptcy counterclaims that may constitute as
set-offs against the claims asserted by CBTM. Subsequent to
issuing the injunction order, Bankruptcy Judge Gerber held
several conferences urging the parties to submit their dispute
to court-ordered mediation. In conjunction with the Bankruptcy
Courts request, District Court Judge Pauley ordered a stay
of all remaining expert discovery and motion procedures pending
the participation and completion of mediation as requested by
Bankruptcy Court Judge Gerber. The matter was then transferred
to mediation by order of the Courts.

In September, 2004, the parties selected Harvey
A. Stricken, Esq. as mediator to the dispute. On
October 6, 2004, the mediation was held with no particular
outcome. Mr. Stricken has asked for follow-up discussions
with the parties on an individual basis to determine whether
continued mediation is warranted.

Pursuant to an October 1, 2004 Order of
Judge Pauley, the parties are to advise the District Court of
any disposition of the bankruptcy proceedings. A telephone
status conference on December 3, 2004 will also be held by
Judge Pauley. The stay of expert discovery and motion procedures
shall continue until that date. Because of the uncertain outcome
of such mediation, we are unable to predict the possible outcome
of this matter, if any, on our business, financial condition,
results of operations or cash flows.

Avasta Earnout

On October 14, 2003, we received a letter
purportedly on behalf of the former stockholders of Avasta, Inc.
relating to the issuance of additional shares of common stock
pursuant to the earnout calculations pursuant to the Agreement
and Plan of Merger and Reorganization dated as of
January 29, 2003 among Avasta Acquisition Corp., Avasta and
NaviSite. On December 11, 2003, a demand for arbitration
before JAMS (formerly known as Judicial Arbitration and
Mediation Services) was filed by Convergence Associates, Inc.
(Convergence Associates) on behalf of substantially
all of the former shareholders of Avasta claiming among other
things breach of contract, tortious conduct, fraud and other
wrongful conduct. Damages sought included in excess of
782,790 shares of our common stock. On September 30,
2004, the arbitrator issued a decision with respect to the
demand for arbitration. The arbitrator found that we breached
our obligations under the Agreement and ordered us to issue to
the former Avasta shareholders, or their designee, an aggregate
of 321,880 shares of our common stock. In addition, the
arbitrator determined that, as the prevailing party, Convergence
Associates is entitled to recover from us its reasonable
attorneys fees, costs and disbursements. On
October 11, 2004, Convergence Associates submitted its
application for reasonable attorneys fees, costs and
disbursements in the range of approximately $750,957 to
$957,000. We filed an objection to Convergence Associates
proposed fees on October 25, 2004. Convergence Associates
has until November 2, 2004 to respond to our objection.
When the arbitrator makes the final award of fees, that order,
together with the decision issued on September 30, 2004,
will constitute the final, non-appealable award of the
arbitrator. (See Note 8)

Engage Bankruptcy Trustee Claim

On September 9, 2004, Don Hoy, Craig R.
Jalbert and David St. Pierre, as trustees of and on behalf of
the Engage, Inc. creditor trust, filed suit against us in the
United States Bankruptcy Court in the District of Massachusetts.
The suit generally relates to a termination agreement, dated
March 7, 2002, we entered into with Engage, Inc. (a company
then affiliated with CMGI, Inc.), which terminated a services
agreement between us and Engage and required Engage to pay us
$3.6 million. Engage made three payments to us under the
termination agreement in the aggregate amount of
$3.4 million. On June 19, 2003, Engage and five of its
wholly owned subsidiaries filed petitions for relief under
Chapter 11 of Title 11 of the United States Bankruptcy
Code. The suit generally alleges that Engage was insolvent at
the time that we entered into the

F-34



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

termination agreement with Engage and at the time
Engage made the payments to us. Specifically, the suit alleges
that (i) the plaintiffs are entitled to avoid and recover
$1.0 million paid by Engage to us in the year prior to
June 19, 2003 as a preferential transfer, (ii) the
plaintiffs are entitled to avoid and recover $3.4 million
(which amount includes the $1.0 million payment made prior
to June 13, 2003) paid by Engage to us as a fraudulent
transfer, and (iii) our acts and omissions relating to the
termination agreement and the payments made by Engage to us
constitute unfair and deceptive acts or practices in willful and
knowing violation of Mass. Gen. Laws ch. 93A. In addition
to the foregoing amounts, the plaintiffs are also seeking treble
damages, attorneys fees and costs under Mass. Gen. Laws
ch. 93A. As this matter is in the initial stage, we are not
able to predict the possible outcome of this matter and the
effect, if any, on our business, financial condition, results of
operations or cash flow, except that we believe we have certain
meritorious defenses to the claims asserted in the complaint
which we intend to assert vigorously.



|     |             
|---- | ------------
|(13) | Income Taxes

Total income tax expense (benefit) for the
periods ending July 31, 2004, July 31, 2003 and
July 31, 2002, consisted of the following:

|        |  |                |   |               |  |               |   |         |  |          |   |       |  |         |      |          |  |       |     |  |  |   |     |  |  |   |   |  |  |   |   |  |  |   |   | 
|------- |  | -------------- | - | ------------- |  | ------------- | - | ------- |  | -------- | - | ----- |  | ------- | ---- | -------- |  | ----- | --- |  |  | - | --- |  |  | - | - |  |  | - | - |  |  | - | - | 
|        |  |                |   |               |  |              
|        |  | July 31, 2004  |   | July 31, 2004 |  | July 31, 2004
|        |  |                |   |               |  |              
|        |  | Current        |   | Deferred      |  | Total         |   | Current |  | Deferred |   | Total |  | Current |      | Deferred |  | Total
|        |  |                |   |               |  |               |   |         |  |          |   |       |  |         |      |          |  |      
|        |  |               
|        |  | (In thousands)
|Federal |  | $              |  |               |  | $             |  |         |  | $        |  |       |  | $       | (513 | )        |  | $     | 513 |  |  | $ |    |  |  | $ |  |  |  | $ |  |  |  | $ |  | 
|Foreign |  |                | 1 |               |  |               |  |         |  |          | 1 |       |  |         |     |          |  |       |    |  |  |   |    |  |  |   |  |  |  |   |  |  |  |   |  | 
|State   |  |                |  |               |  |               |  |         |  |          |  |       |  |         | 153  |          |  |       |    |  |  |   | 153 |  |  |   |  |  |  |   |  |  |  |   |  | 
|        |  |                |   |               |  |               |   |         |  |          |   |       |  |         |      |          |  |       |     |  |  |   |     |  |  |   |   |  |  |   |   |  |  |   |   | 
|        |  | $              | 1 |               |  | $             |  |         |  | $        | 1 |       |  | $       | (360 | )        |  | $     | 513 |  |  | $ | 153 |  |  | $ |  |  |  | $ |  |  |  | $ |  | 
|        |  |                |   |               |  |               |   |         |  |          |   |       |  |         |      |          |  |       |     |  |  |   |     |  |  |   |   |  |  |   |   |  |  |   |   | 

The actual income tax expense for the periods
ending July 31, 2004, July 31, 2003, and July 31,
2002 differs from the expected tax expense for these periods as
follows:

|                                               |  |                |        |               |  |               |         |   |  |   |         |  
|---------------------------------------------- |  | -------------- | ------ | ------------- |  | ------------- | ------- | - |  | - | ------- | -
|                                               |  | July 31, 2004  |        | July 31, 2004 |  | July 31, 2004
|                                               |  |                |        |               |  |              
|                                               |  |               
|                                               |  | (In thousands)
|Computed expected tax expense
    (benefit)  |  | $              | (7,260 | )             |  | $             | (24,981 | ) |  | $ | (41,376 | )
|State taxes, net of federal income tax benefit |  |                |       |               |  |               | 101     |   |  |   |        |  
|Losses not benefited                           |  |                | 7,261  |               |  |               | 25,033  |   |  |   | 41,376  |  
|                                               |  |                |        |               |  |               |         |   |  |   |         |  
|Total                                          |  | $              | 1      |               |  | $             | 153     |   |  | $ |        |  
|                                               |  |                |        |               |  |               |         |   |  |   |         |  

Temporary differences between the financial
statement carrying and tax bases of assets and liabilities that
give rise to significant portions of deferred tax assets
(liabilities) are comprised of the following:

|                                      |  |                |         |               |  |   |         |  
|------------------------------------- |  | -------------- | ------- | ------------- |  | - | ------- | -
|                                      |  | July 31, 2004  |         | July 31, 2004
|                                      |  |                |         |              
|                                      |  |               
|                                      |  | (In thousands)
|Deferred tax assets:                  |  |                |         |               |  |   |         |  
|Accruals and reserves                 |  | $              | 6,422   |               |  | $ | 4,455   |  
|Loss carryforwards                    |  |                | 30,943  |               |  |   | 20,709  |  
|Depreciation and amortization         |  |                | 25,579  |               |  |   | 33,134  |  
|                                      |  |                |         |               |  |   |         |  
|Total deferred tax assets             |  | $              | 62,944  |               |  | $ | 58,298  |  
|Less: Valuation allowance             |  |                | (62,944 | )             |  |   | (58,298 | )
|                                      |  |                |         |               |  |   |         |  
|Net deferred tax (assets) liabilities |  | $              |        |               |  | $ |        |  
|                                      |  |                |         |               |  |   |         |  

F-35



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Valuation allowance increased by
$4.6 million and decreased by $84.2 million for the
years ended July 31, 2004 and 2003, respectively. Reported
tax benefits related to approximately $0.2 million of the
valuation allowance at July 31, 2004 will be recorded as an
increase to paid-in capital, if realized, as it related to tax
benefits from stock-based compensation.

The Company has recorded a full valuation
allowance against its deferred tax assets since management
believes that, after considering all the available objective
evidence, both positive and negative, historical and
prospective, with greater weight given to historical evidence,
it is not more likely than not that these assets will be
realized.

As a result of the transaction on
September 11, 2002, the Company experienced a change in
ownership as defined in Section 382 of the Internal Revenue
Code. As a result of the change in ownership, the utilization of
its federal and state tax net operating losses generated prior
to the transaction is subject to an annual limitation of
approximately $1.2 million. As a result of this limitation,
the Company expects that a substantial portion of its federal
and state net operating loss carryforwards will expire unused.

The Company has net operating loss carryforwards
for federal and state tax purposes of approximately
$78.4 million, after taking into consideration net
operating losses expected to expire unused due to the
Section 382 limitation. The federal net operating loss
carryforwards will expire from fiscal year 2011 to fiscal year
2024 and the state net operating loss carryforwards will expire
from fiscal year 2008 to fiscal year 2024. The utilization of
these net operating loss carryforwards may be further limited if
the Company experiences additional ownership changes as defined
in Section 382 of the Internal Revenue Code.



|     |                     
|---- | --------------------
|(14) | Stockholders Equity



| |                         
| | ------------------------
| | Issuance of Common Stock

On December 12, 2002, CBT cancelled warrants
to purchase 346,883 shares of our common stock at
exercise prices ranging from $86.55 to $103.80 per share.

We have accounted for the 567,978 shares
issued to CBT on December 31, 2002, in connection with the
acquisition of CBTM, as a dividend distribution to CBT because
CBT and its affiliates were considered to have controlling
interest over both CBTM and NaviSite. As a result, we reported
an increase to accumulated deficit of $1.3 million, which
represents the number of common shares issued at the then
current market value of $2.25 per share.

On February 5, 2003, we issued
231,039 shares of our common stock at a per share value of
$1.60 in connection with the acquisition of Avasta (see
Note 8). In September 2003, we issued 179,353 shares
of our common stock at a per share value of $4.14 (representing
the market value of our common stock the day preceding the
issuance of the additional shares) for the attainment of certain
revenue targets in conjunction with the Avasta acquisition.

On August 8, 2003, we issued
1,100,000 shares of our common stock to CBT at a per share
value of $2.55 in connection with the acquisition of certain
assets of CBT (see Note 8). The issuance of these shares
has been accounted for as a dividend distribution because
Atlantic Investors, LLC and its affiliates are considered to
have controlling interest in both CBT and NaviSite. As a result,
we reported a reduction of retained earnings of
$2.8 million, which represents the number of common shares
issued at the then current market value of $2.55 per share.

During 2003, we had an insufficient number of
stock options remaining within our existing shareholder approved
stock option plans for grants to our independent Board of
Directors and members of management. At our 2003 annual meeting
of stockholders, held on December 9, 2003, our stockholders
approved our Amended and Restated 2003 Stock Incentive Plan and
we granted stock options to members of our independent Board of
Directors and certain members of management at that time. These
stock options were

F-36



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

granted to the independent members of our Board
of Directors and management at strike prices similar to the
period that the stock options would have been granted had
sufficient shareholder approved stock options been available for
grant at that time. Because the strike price of these stock
options represented a discount from the market value of our
stock on the date of grant, we recorded approximately
$2.0 million of deferred compensation expense, which will
be amortized into compensation expense over the vesting period
of the stock options. During the year ended July 31, 2004,
the Company reported compensation expense of approximately
$473,000 for these options. The remaining unamortized
compensation charge of $1.5 million is recorded as deferred
compensation, which is a component of stockholders equity.

As part of the Silicon Valley Bank Financing
Agreement, on May 27, 2003 we issued to SVB a warrant to
purchase up to 165,000 shares of NaviSite common stock with
an exercise price of $2.50 per share, the closing price of
our stock on the last business day before the issuance of the
warrant. We fair valued the warrants at $370,000 using the
Black-Scholes option-pricing model. The value of the warrants
was amortized into interest expense over the term of the
Financing Agreement. Pursuant to the terms of the warrant, on
May 19, 2004, SVB fully exercised its warrant, which
resulted in a net issuance of 73,738 shares (see
Note 11).

In connection with our amended Silicon Valley
Bank Financing Agreement, on January 30, 2004, we issued a
warrant to SVB for the purchase of 50,000 shares of common
stock at an exercise price of $5.75 per share. We fair
valued the warrant at $213,426 using the Black-Scholes
option-pricing model. The value of the warrant is being
amortized into interest expense over the term of the modified
Financing Agreement. The warrant is exercisable at any time on
or after September 1, 2004. Pursuant to the terms of a
Registration Rights Agreement, dated as of January 30,
2004, we also granted certain registration rights to SVB with
respect to the shares of common stock issuable upon exercise of
the warrant (see Note 11).

On June 10, 2004, we issued
3,000,000 shares of our common stock at a per share value
of $4.55, in connection with the acquisition of certain assets
and liabilities of Surebridge (see Note 8).

(15) Stock Option Plans



| |                                          
| | -----------------------------------------
| | (a) 1999 Employee Stock Purchase
    Plan

The 1999 Employee Stock Purchase Plan (the
Stock Purchase Plan) was adopted by NaviSites
Board of Directors and Stockholders in October 1999. The Stock
Purchase Plan provides for the issuance of a maximum of
16,666 shares of our Common Stock. The Plan allows
participants to purchase shares at 85% of the closing price of
Common Stock on the first business day of the Plan period or the
last business day of the Plan period, whichever closing price is
less.

During fiscal year 2004, no additional shares
were issued under this plan. We issued a total of
16,657 shares since the plans inception.



| |                                        
| | ---------------------------------------
| | (b) NaviSite 2000 Stock Option
    Plan

In November 2000, NaviSites Board of
Directors approved the 2000 Stock Option Plan (the
Plan). Under the Plan, nonqualified stock options or
incentive stock options may be granted to NaviSites
employees, other than those who are also officers or directors,
and our consultants and advisors, as defined, up to a maximum
number of shares of Common Stock not to exceed
66,666 shares. The board of directors administers this
plan, selects the individuals who are eligible to be granted
options under the Plan and determines the number of shares and
exercise price of each option. Options granted under the Plan
have a five-year maximum term and typically vest over a one-year
period. On December 9, 2003, the NaviSite Stockholders
approved the 2003 Stock Incentive Plan and will grant no
additional options under the Plan.

F-37



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The following table reflects stock option
activity under the Plan for the years ended July 31, 2004,
2003 and 2002, respectively:

|                                         |  |        |        |          |  |        |        |          |  |        |         |          |  |   |        |  |  |  |         |   |  |   |        | 
|---------------------------------------- |  | ------ | ------ | -------- |  | ------ | ------ | -------- |  | ------ | ------- | -------- |  | - | ------ |  |  |  | ------- | - |  | - | ------ | 
|                                         |  |        |        |          |  |       
|                                         |  | 2004   |        | 2003     |  | 2002  
|                                         |  |        |        |          |  |       
|                                         |  |        |        | Weighted |  |        |        | Weighted |  |        |         | Weighted
|                                         |  | Number |        | Average  |  | Number |        | Average  |  | Number |         | Average 
|                                         |  | of     |        | Exercise |  | of     |        | Exercise |  | of     |         | Exercise
|                                         |  | Shares |        | Price    |  | Shares |        | Price    |  | Shares |         | Price   
|                                         |  |        |        |          |  |        |        |          |  |        |         |         
|Options outstanding, beginning of year   |  |        | 4,872  |          |  | $      | 128.44 |          |  |        | 16,266  |          |  | $ | 128.44 |  |  |  | 32,157  |   |  | $ | 128.44 | 
|Granted                                  |  |        |       |          |  |        |       |          |  |        |        |          |  |   |       |  |  |  |        |   |  |   |       | 
|Exercised                                |  |        |       |          |  |        |       |          |  |        |        |          |  |   |       |  |  |  |        |   |  |   |       | 
|Cancelled                                |  |        | (1,164 | )        |  | $      | 128.44 |          |  |        | (11,394 | )        |  | $ | 128.44 |  |  |  | (15,891 | ) |  | $ | 128.44 | 
|                                         |  |        |        |          |  |        |        |          |  |        |         |          |  |   |        |  |  |  |         |   |  |   |        | 
|Options outstanding, end of year         |  |        | 3,708  |          |  | $      | 128.44 |          |  |        | 4,872   |          |  | $ | 128.44 |  |  |  | 16,266  |   |  | $ | 128.44 | 
|                                         |  |        |        |          |  |        |        |          |  |        |         |          |  |   |        |  |  |  |         |   |  |   |        | 
|Options exercisable, end of year         |  |        | 3,708  |          |  |        |        |          |  |        | 4,872   |          |  |   |        |  |  |  | 16,266  |   |  |   |        | 
|                                         |  |        |        |          |  |        |        |          |  |        |         |          |  |   |        |  |  |  |         |   |  |   |        | 
|Options available for grant, end of year |  |        |       |          |  |        |        |          |  |        | 61,794  |          |  |   |        |  |  |  | 50,400  |   |  |   |        | 
|                                         |  |        |        |          |  |        |        |          |  |        |         |          |  |   |        |  |  |  |         |   |  |   |        | 

(c) NaviSite
1998 Equity Incentive Plan

In December 1998, NaviSites Board of
Directors and Stockholders approved the 1998 Equity Incentive
Plan, as amended (the 1998 Plan). The 1998 Plan
replaced NaviSite Internet Services Corporations 1997
Equity Incentive Plan (the 1997 Plan). All options
outstanding under the 1997 Plan were cancelled and replaced with
an equivalent amount of options issued in accordance with the
1998 Plan. Under the original 1998 Plan, nonqualified stock
options or incentive stock options may be granted to
NaviSites or its affiliates employees, directors,
and consultants, as defined, up to a maximum number of shares of
Common Stock not to exceed 333,333 shares. In August 1999,
the Board of Directors approved an increase in the number of
shares authorized under the 1998 Plan to 741,628. In December
2000, the Board of Directors approved an additional increase in
the number of shares authorized under the 1998 Plan to
1,000,000 shares. The Board of Directors administers this
plan, selects the individuals who are eligible to be granted
options under the 1998 Plan and determines the number of shares
and exercise price of each option. The chief executive officer,
upon authority granted by the board of directors, is authorized
to approve the grant of options to purchase Common Stock under
the 1998 Plan to certain persons. Options are granted at fair
market value. Options granted under the 1998 Plan have a
five-year maximum term and typically vest over a four year
period, with 25% of options granted becoming exercisable one
year from the date of grant and the remaining 75% vesting
monthly for the next thirty-six (36) months. On
December 9, 2003, the NaviSite stockholders approved the
2003 Stock Incentive Plan and will grant no additional options
under the 1998 Plan.

F-38



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The following table reflects activity and
historical exercise prices of stock options under our 1998 Plan
for the three years ended July 31, 2004, 2003 and 2002,
respectively:

|                                         |  |           |         |          |  |           |       |          |  |           |          |          |  |   |        |  |  |  |          |   |  |   |        | 
|---------------------------------------- |  | --------- | ------- | -------- |  | --------- | ----- | -------- |  | --------- | -------- | -------- |  | - | ------ |  |  |  | -------- | - |  | - | ------ | 
|                                         |  |           |         |          |  |          
|                                         |  | 2004      |         | 2003     |  | 2002     
|                                         |  |           |         |          |  |          
|                                         |  |           |         | Weighted |  |           |       | Weighted |  |           |          | Weighted
|                                         |  |           |         | Average  |  |           |       | Average  |  |           |          | Average 
|                                         |  | Number of |         | Exercise |  | Number of |       | Exercise |  | Number of |          | Exercise
|                                         |  | Shares    |         | Price    |  | Shares    |       | Price    |  | Shares    |          | Price   
|                                         |  |           |         |          |  |           |       |          |  |           |          |         
|Options outstanding, beginning of year   |  |           | 265,969 |          |  | $         | 66.14 |          |  |           | 452,801  |          |  | $ | 149.40 |  |  |  | 522,560  |   |  | $ | 276.00 | 
|Granted                                  |  |           | 40,000  |          |  | $         | 3.53  |          |  |           | 128,164  |          |  | $ | 2.57   |  |  |  | 268,397  |   |  | $ | 4.65   | 
|Exercised                                |  |           | (11,006 | )        |  | $         | 2.44  |          |  |           | (1,905   | )        |  | $ | 1.18   |  |  |  | (34,901  | ) |  | $ | 1.05   | 
|Cancelled                                |  |           | (62,910 | )        |  | $         | 87.61 |          |  |           | (313,091 | )        |  | $ | 160.79 |  |  |  | (303,255 | ) |  | $ | 256.35 | 
|                                         |  |           |         |          |  |           |       |          |  |           |          |          |  |   |        |  |  |  |          |   |  |   |        | 
|Options outstanding, end of year         |  |           | 232,053 |          |  | $         | 52.59 |          |  |           | 265,969  |          |  | $ | 66.14  |  |  |  | 452,801  |   |  | $ | 149.40 | 
|                                         |  |           |         |          |  |           |       |          |  |           |          |          |  |   |        |  |  |  |          |   |  |   |        | 
|Options exercisable, end of year         |  |           | 224,005 |          |  | $         | 54.02 |          |  |           | 175,555  |          |  | $ | 84.18  |  |  |  | 131,156  |   |  | $ | 294.60 | 
|                                         |  |           |         |          |  |           |       |          |  |           |          |          |  |   |        |  |  |  |          |   |  |   |        | 
|Options available for grant, end of year |  |           |        |          |  |           |       |          |  |           | 571,661  |          |  |   |        |  |  |  | 386,606  |   |  |   |        | 
|                                         |  |           |         |          |  |           |       |          |  |           |          |          |  |   |        |  |  |  |          |   |  |   |        | 

|                         |  |                     |         |                     |  |          |      |             |  |          |        |  |  |  |         |  |  |   |        | 
|------------------------ |  | ------------------- | ------- | ------------------- |  | -------- | ---- | ----------- |  | -------- | ------ |  |  |  | ------- |  |  | - | ------ | 
|                         |  |                     |         |                    
|                         |  | Options Outstanding |         | Options Exercisable
|                         |  |                     |         |                    
|                         |  |                     |         | Weighted            |  |          |      |            
|                         |  |                     |         | Average             |  | Weighted |      |             |  | Weighted
|                         |  |                     |         | Remaining           |  | Average  |      |             |  | Average 
|                         |  | Number              |         | Contractual         |  | Exercise |      | Number      |  | Exercise
|Range of Exercise Prices |  | Outstanding         |         | Life (Years)        |  | Price    |      | Outstanding |  | Price   
|                         |  |                     |         |                     |  |          |      |             |  |         
|$0.01 -   2.55           |  |                     | 121,141 |                     |  |          | 8.89 |             |  | $        | 2.55   |  |  |  | 120,465 |  |  | $ | 2.55   | 
|$2.56 -   3.75           |  |                     | 40,166  |                     |  |          | 9.15 |             |  | $        | 3.53   |  |  |  | 35,100  |  |  | $ | 3.53   | 
|$3.76 -   3.90           |  |                     | 33,626  |                     |  |          | 2.64 |             |  | $        | 3.90   |  |  |  | 33,626  |  |  | $ | 3.90   | 
|$3.91 -   15.47          |  |                     | 7,854   |                     |  |          | 1.67 |             |  | $        | 15.04  |  |  |  | 6,462   |  |  | $ | 15.14  | 
|$15.48 -   73.13         |  |                     | 8,924   |                     |  |          | 1.58 |             |  | $        | 34.17  |  |  |  | 8,131   |  |  | $ | 33.94  | 
|$73.14 -   182.82        |  |                     | 6,127   |                     |  |          | 0.36 |             |  | $        | 114.38 |  |  |  | 6,044   |  |  | $ | 113.72 | 
|$182.83 -   671.25       |  |                     | 6,255   |                     |  |          | 0.81 |             |  | $        | 615.24 |  |  |  | 6,217   |  |  | $ | 615.71 | 
|$671.26 and up           |  |                     | 7,960   |                     |  |          | 0.52 |             |  | $        | 835.33 |  |  |  | 7,960   |  |  | $ | 835.33 | 
|                         |  |                     |         |                     |  |          |      |             |  |          |        |  |  |  |         |  |  |   |        | 
|                         |  |                     | 232,053 |                     |  |          |      |             |  |          |        |  |  |  | 224,005 |  |  |   |        | 
|                         |  |                     |         |                     |  |          |      |             |  |          |        |  |  |  |         |  |  |   |        | 

(d) NaviSite
2003 Stock Option Plan

On July 10, 2003, the 2003 Stock Incentive
Plan (the 2003 Plan) was approved by the Board of
Directors and was approved by the NaviSite Stockholders on
December 9, 2003. The 2003 Plan provides that stock options
or restricted stock awards may be granted to employees,
officers, directors, consultants, and advisors or NaviSite (or
any present or future parent or subsidiary corporations and any
other business venture (including, without limitation, joint
venture or limited liability company) in which NaviSite has a
controlling interest, as determined by the Board of Directors of
NaviSite). The Board of Directors authorized
2,600,000 shares of Common Stock for issuance under the
2003 Plan. On November 11, 2003, the 2003 Plan was amended
to increase the number of available shares from 2,600,000 to
3,800,000. An amendment has been filed to add an additional
3,000,000 shares to the 2003 Plan. This amendment is
subject to Stockholder approval. Upon approval of this
amendment, there will be 6,800,000 shares authorized under
the 2003 Plan.

The 2003 Plan is administered by the Board of
Directors of NaviSite or any committee to which the Board
delegates its powers under the 2003 Plan. Subject to the
provisions of the 2003 Plan, the Board of

F-39



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Directors will determine the terms of each award,
including the number of shares of common stock subject to the
award and the exercise thereof.

The Board of Directors may, in its sole
discretion, amend, modify or terminate any award granted or made
under the 2003 Plan, so long as such amendment, modification or
termination would not materially and adversely affect the
participant. The Board of Directors may also provide that any
stock option shall become immediately exercisable, in full or in
part, or that any restricted stock granted under the 2003 Plan
shall be free of some or all restrictions.

As of July 31, 2004, stock options to
purchase 3,492,287 shares of common stock at an
average exercise price of $3.85 per share were outstanding
under the 2003 Plan. The options are exercisable as to 25% of
the original number of shares on the six month anniversary of
the optionholder and thereafter in equal amounts monthly over
the three year period commencing on the six month anniversary of
the optionholder. Options granted under the 2003 Plan have a
maximum term of ten years.

The following table reflects activity and
historical exercise prices of stock options under the 2003 Plan
for the two years ended July 31, 2004, and 2003,
respectively:

|                                         |  |           |           |          |  |           |      |          |  |  |           |   |  |   |      | 
|---------------------------------------- |  | --------- | --------- | -------- |  | --------- | ---- | -------- |  |  | --------- | - |  | - | ---- | 
|                                         |  |           |           |         
|                                         |  | 2004      |           | 2003    
|                                         |  |           |           |         
|                                         |  |           |           | Weighted |  |           |      | Weighted
|                                         |  |           |           | Average  |  |           |      | Average 
|                                         |  | Number of |           | Exercise |  | Number of |      | Exercise
|                                         |  | Shares    |           | Price    |  | Shares    |      | Price   
|                                         |  |           |           |          |  |           |      |         
|Options outstanding, beginning of year   |  |           | 2,189,000 |          |  | $         | 2.55 |          |  |  |          |   |  | $ |     | 
|Granted                                  |  |           | 1,967,375 |          |  | $         | 4.92 |          |  |  | 2,272,000 |   |  | $ | 2.55 | 
|Exercised                                |  |           | (148,079  | )        |  | $         | 2.55 |          |  |  |          |   |  | $ |     | 
|Cancelled                                |  |           | (516,009  | )        |  | $         | 2.75 |          |  |  | (83,000   | ) |  | $ | 2.55 | 
|                                         |  |           |           |          |  |           |      |          |  |  |           |   |  |   |      | 
|Options outstanding, end of year         |  |           | 3,492,287 |          |  | $         | 3.85 |          |  |  | 2,189,000 |   |  | $ | 2.55 | 
|                                         |  |           |           |          |  |           |      |          |  |  |           |   |  |   |      | 
|Options exercisable, end of year         |  |           | 1,340,969 |          |  | $         | 3.58 |          |  |  |          |   |  | $ |     | 
|                                         |  |           |           |          |  |           |      |          |  |  |           |   |  |   |      | 
|Options available for grant, end of year |  |           | 159,634   |          |  |           |      |          |  |  | 411,000   |   |  |   |      | 
|                                         |  |           |           |          |  |           |      |          |  |  |           |   |  |   |      | 

|                         |  |                     |           |                     |  |          |      |             |  |          |      |  |  |  |           |  |  |   |      | 
|------------------------ |  | ------------------- | --------- | ------------------- |  | -------- | ---- | ----------- |  | -------- | ---- |  |  |  | --------- |  |  | - | ---- | 
|                         |  |                     |           |                    
|                         |  | Options Outstanding |           | Options Exercisable
|                         |  |                     |           |                    
|                         |  |                     |           | Weighted            |  |          |      |            
|                         |  |                     |           | Average             |  | Weighted |      |             |  | Weighted
|                         |  |                     |           | Remaining           |  | Average  |      |             |  | Average 
|                         |  | Number              |           | Contractual         |  | Exercise |      | Number      |  | Exercise
|Range of Exercise Prices |  | Outstanding         |           | Life (Years)        |  | Price    |      | Outstanding |  | Price   
|                         |  |                     |           |                     |  |          |      |             |  |         
|$0.01 - 2.55             |  |                     | 1,835,081 |                     |  |          | 8.92 |             |  | $        | 2.55 |  |  |  | 857,414   |  |  | $ | 2.55 | 
|$2.56 - 5.31             |  |                     | 390,374   |                     |  |          | 9.50 |             |  | $        | 4.52 |  |  |  | 88,448    |  |  | $ | 4.62 | 
|$5.32 - 5.42             |  |                     | 1,004,000 |                     |  |          | 9.55 |             |  | $        | 5.41 |  |  |  | 300,000   |  |  | $ | 5.41 | 
|$5.43 - 5.69             |  |                     | 217,832   |                     |  |          | 9.49 |             |  | $        | 5.69 |  |  |  | 73,550    |  |  | $ | 5.69 | 
|$5.70 and up             |  |                     | 45,000    |                     |  |          | 9.37 |             |  | $        | 7.73 |  |  |  | 21,557    |  |  | $ | 7.85 | 
|                         |  |                     |           |                     |  |          |      |             |  |          |      |  |  |  |           |  |  |   |      | 
|                         |  |                     | 3,492,287 |                     |  |          |      |             |  |          |      |  |  |  | 1,340,969 |  |  |   |      | 
|                         |  |                     |           |                     |  |          |      |             |  |          |      |  |  |  |           |  |  |   |      | 

(e) Other
Stock Option Grants

At July 31, 2004, we had 2,665 outstanding
stock options issued outside of existing plans to certain
directors at an average exercise price of $135.56. These stock
options were fully vested on the grant date and have a
contractual life of 10 years.

F-40



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

(f) Other
Disclosure

SFAS No. 123, Accounting for
Stock-Based Compensation, sets forth a fair-value based
method of recognizing stock-based compensation expense. As
permitted by SFAS No. 123, we have elected to continue
to apply APB No. 25 to account for the stock-based
compensation plans in which NaviSites employees
participate.

(16) Related Party Transactions

For the period August 1, 2002 through
September 11, 2002, we classified revenue from CMGI and
CMGI affiliates as revenue from related parties. For all periods
subsequent to September 12, 2002, we classified revenue
from CMGI and CMGI affiliates as third-party revenue.

The consolidated financial statements for the
three and twelve-month periods ended July 31, 2003 include
certain allocations from CMGI for certain general and
administrative expenses, such as rent, legal services,
insurance, and employee benefits. Allocations are based
primarily on headcount. Management believes that the method used
to allocate the costs and expenses is reasonable; however, such
allocated amounts may or may not necessarily be indicative of
what actual expenses would have been incurred had we operated
independently of CMGI. As a result of CMGIs sale of its
debt and equity interests in us to CBT, the agreement between
NaviSite and CMGI whereby CMGI provided certain services to us
automatically terminated. CMGI continued to provide certain
services to us pursuant to a Transition Services Agreement we
entered into with CMGI on November 25, 2002, as we
transitioned to service offerings from CBT and other third-party
suppliers. This transition agreement concluded during the second
quarter of fiscal year 2003 and we have completely severed our
administrative ties with CMGI; however, CMGI remains a
third-party customer. During the second quarter of fiscal year
2003, we contracted with CBT and other third-party suppliers for
these services. We currently rent administrative facilities from
CMGI at 800 Federal Street, Andover, Massachusetts.

On December 31, 2002, CBTM was required to
pay a $6.1 million liability owed to the AppliedTheory
Estate as a result of CBTMs acquisition of AppliedTheory.
In order to fund the $6.1 million payment, CBTM entered
into a $6.0 million line of credit with Unicorn Worldwide
Holding Limited (Unicorn), a related party to NaviSite and CBTM.
CBTM drew down $4.6 million and together with cash on hand
at December 31, 2002, paid the $6.1 million liability
due to the AppliedTheory Estate. In January 2003, CBTM paid
$2.6 million of the $4.6 million due to Unicorn,
leaving a liability to Unicorn of $2.0 million at
January 31, 2003. In January 2003, we entered into a Loan
and Security Agreement with Atlantic and in February 2003, drew
down on this facility to pay off the remaining $2.0 million
due Unicorn by CBTM.

On January 29, 2003, we entered into a
$10.0 million Loan and Security Agreement (Atlantic Loan)
with Atlantic, a related party. The Atlantic Loan bears an
interest rate of 8% per annum. Interest is payable upon
demand or, at Atlantics option, interest may be added to
the outstanding balance due to Atlantic by NaviSite. Atlantic
may make demand for payment of amounts in excess of the minimum
Atlantic Loan amount of $2.0 million (Minimum
Loan Amount), with 60 days notice. Atlantic can demand
payment of the Minimum Loan Amount with 90 days
notice. Under the Atlantic Loan agreement, we can require
Atlantic to loan us (1) up to $2.0 million to repay an
amount due from CBTM to Unicorn, a related party to NaviSite and
Atlantic; (2) $1.0 million for costs associated with
our acquisition of Avasta; and (3) up to $500,000 for the
post-acquisition working capital needs of Avasta. Atlantic, at
its sole and absolute discretion, may advance other amounts to
us such that the aggregate amount borrowed by NaviSite does not
exceed the maximum loan amount, defined as the lesser of
$10.0 million or 65% of our consolidated accounts
receivables. At July 31, 2004 and July 31, 2003, we
had $3.0 million outstanding under the Atlantic Loan. This
amount is shown as a current note payable to related party on
our Consolidated Balance Sheet. The Atlantic Loan is secured by
all of our receivables, and is subordinate to Silicon Valley
Bank. On May 30, 2003 we repaid $2.0 million of the
approximate $3.0 million outstanding under the Atlantic
Loan and on June 11, 2003, we borrowed $2.0 million

F-41



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##### Table of Contents



NAVISITE, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

under the Atlantic Loan (see Note 9). On
January 16, 2004, the Atlantic Loan was amended to extend
any and all Credit Advances under the Atlantic Loan made prior
to, or following January 16, 2004 to be due on or before
the earlier of (i) August 1, 2004 or (ii) five
(5) business days following the closing of a financing
transaction or disposition pursuant to which the Borrower
receives gross proceeds of $13.0 million. On July 13,
2004, the Atlantic Loan was further amended to extend any and
all Credit Advances under the Atlantic Loan to be due on or
before the earlier of (i) November 1, 2004 or
(ii) five (5) business days following the closing of a
financing transaction or disposition pursuant to which we
receive net proceeds of $13.0 million. On October 12,
2004, the Atlantic Loan was amended to extend any and all Credit
Advances under the Atlantic Loan made prior to, or following,
October 12, 2004, to be due on or before the earlier of
(i) February 1, 2005 or (ii) five
(5) business days following the closing of a financing
transaction or disposition pursuant to which the Borrower
receives net proceeds of $13.0 million after satisfying the
mandatory prepayment obligations under those certain Notes due
to Surebridge, Inc.

ClearBlue
Technologies (UK) Limited Outsourcing
Agreement

Beginning April 1, 2004, we entered into an
Outsourcing Agreement with ClearBlue Technologies
(UK) Limited (ClearBlue) whereby, the Company
will provide certain management services as well as manage the
day-to-day operations as required by ClearBlues
customers contracts. The Company charges ClearBlue a
monthly fee of £4,700, plus 20% of gross profit (gross
profit is revenue collected from ClearBlue customers, less the
monthly fee), but in the event such calculation is less than $0,
100% of the gross profit shall remain with ClearBlue. During the
fiscal year ended July 31, 2004, the Company charged
ClearBlue approximately $46,000 under this agreement, which has
been included in Revenue, related parties in the Consolidated
Statements of Operations. As of July 31, 2004, there are no
amounts outstanding under this agreement.

(15) Selected Quarterly Financial Data
(Unaudited)

Financial information for interim periods was as
follows:

|                             |  |                                 |        |    |  |    |        |    |  |   |        |   |  |   |         |  
|---------------------------- |  | ------------------------------- | ------ | -- |  | -- | ------ | -- |  | - | ------ | - |  | - | ------- | -
|                             |  |                                
|                             |  | Fiscal Year Ended July 31, 2004
|                             |  |                                
|                             |  | Q1                              |        | Q2 |  | Q3 |        | Q4
|                             |  |                                 |        |    |  |    |        |   
|                             |  |                                
|                             |  | (In thousands)                 
|Revenue                      |  | $                               | 23,473 |    |  | $  | 22,329 |    |  | $ | 20,185 |   |  | $ | 25,185  |  
|Gross profit                 |  |                                 | 4,916  |    |  |    | 5,571  |    |  |   | 5,968  |   |  |   | 5,421   |  
|Net loss                     |  |                                 | (3,353 | )  |  |    | (3,439 | )  |  |   | (3,026 | ) |  |   | (11,536 | )
|Net loss per common share(a) |  | $                               | (0.14  | )  |  | $  | (0.14  | )  |  | $ | (0.12  | ) |  | $ | (0.43   | )

|                             |  |                                 |         |    |  |    |         |    |  |   |         |   |  |   |         |  
|---------------------------- |  | ------------------------------- | ------- | -- |  | -- | ------- | -- |  | - | ------- | - |  | - | ------- | -
|                             |  |                                
|                             |  | Fiscal Year Ended July 31, 2003
|                             |  |                                
|                             |  | Q1                              |         | Q2 |  | Q3 |         | Q4
|                             |  |                                 |         |    |  |    |         |   
|                             |  |                                
|                             |  | (In thousands)                 
|Revenue                      |  | $                               | 15,871  |    |  | $  | 18,761  |    |  | $ | 19,620  |   |  | $ | 22,339  |  
|Gross profit (loss)          |  |                                 | (624    | )  |  |    | 1,747   |    |  |   | 2,308   |   |  |   | 2,379   |  
|Net loss                     |  |                                 | (10,005 | )  |  |    | (20,231 | )  |  |   | (11,304 | ) |  |   | (32,087 | )
|Net loss per common share(a) |  | $                               | (1.60   | )  |  | $  | (2.07   | )  |  | $ | (0.88   | ) |  | $ | (1.80   | )



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|    |  |                                                                                                                                                                                                                                                                                              
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | Net loss per common share is computed
    independently for each of the quarters based on the weighted
    average number of shares outstanding during the quarter.
    Therefore, the aggregate per share amount for the quarters may
    not equal the amount calculated for the full year.

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##### Table of Contents






REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

ON FINANCIAL STATEMENT SCHEDULE


The Board of Directors and Stockholders

NaviSite, Inc. and Subsidiaries:


Under date of November 1, 2004, we reported
on the consolidated balance sheets of NaviSite, Inc. as of
July 31, 2004 and 2003 and the related consolidated
statements of operations, changes in stockholders equity
(deficit), and cash flows for each of the fiscal years in the
three-year period ended July 31, 2004, which are included
in this Form 10-K. In connection with our audits of the
aforementioned consolidated financial statements, we also
audited the related consolidated financial statement schedule of
Valuation and Qualifying Accounts in this Form 10-K. This
financial statement schedule is the responsibility of the
Companys management. Our responsibility is to express an
opinion on this financial statement schedule based on our
audits. In our opinion, such financial statement schedule when
considered in relation to the basic consolidated financial
statements taken as a whole, presents fairly in all material
respects the information set forth therein.

The audit report on the consolidated financial
statements of NaviSite, Inc. referred to above contains an
explanatory paragraph that states that the Companys
recurring losses since inception and accumulated deficit, as
well as other factors, raise substantial doubt about the
entitys ability to continue as a going concern. The
financial statement schedule does not include any adjustments
that might result from the outcome of this uncertainty.

/s/ KPMG LLP

Boston, Massachusetts

November 1, 2004


F-43



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##### Table of Contents






NaviSite, Inc. and Subsidiaries

Valuation and Qualifying Accounts

|                                |  |                |       |            |  |          |       |            |  |            |       |  |  |   |        |   |  |   |       | 
|------------------------------- |  | -------------- | ----- | ---------- |  | -------- | ----- | ---------- |  | ---------- | ----- |  |  | - | ------ | - |  | - | ----- | 
|                                |  |               
|                                |  |               
|                                |  | Balance at     |       | Additions  |  |          |       | Deductions |  | Balance at
|                                |  | beginning      |       | charged to |  |          |       | from       |  | end of    
|                                |  | of year        |       | expense    |  | Other(1) |       | reserve    |  | year      
|                                |  |                |       |            |  |          |       |            |  |           
|                                |  |               
|                                |  | (In thousands)
|Year ended July 31, 2002:       |  |                |       |            |  |          |       |            |  |            |       |  |  |   |        |   |  |   |       | 
|Allowance for doubtful accounts |  | $              | 6,859 |            |  | $        | 3,490 |            |  | $          |      |  |  | $ | (9,732 | ) |  | $ | 617   | 
|Year ended July 31, 2003:       |  |                |       |            |  |          |       |            |  |            |       |  |  |   |        |   |  |   |       | 
|Allowance for doubtful accounts |  | $              | 617   |            |  | $        | 1,778 |            |  | $          | 3,119 |  |  | $ | (3,484 | ) |  | $ | 2,030 | 
|Year ended July 31, 2004:       |  |                |       |            |  |          |       |            |  |            |       |  |  |   |        |   |  |   |       | 
|Allowance for doubtful accounts |  | $              | 2,030 |            |  | $        | 2,568 |            |  | $          |      |  |  | $ | (2,100 | ) |  | $ | 2,498 | 



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|    |                                                                                                                                                                                                                    
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Represents allowance for doubtful accounts of
    CBTM (fiscal year 2003) and CBT (fiscal year 2004) which were
    accounted for in a manner similar to a pooling-of-interest due
    to common control ownership.

F-44