<PAGE>

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

                                   FORM 10-K

[X]      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
             THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

                   For the fiscal year ended March 31, 2001

[_]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
             THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

          For the transition period from ___________ to _____________

                        Commission file number: 0-27801

                            DATA RETURN CORPORATION
                            -----------------------
            (Exact name of registrant as specified in its charter)

           Texas                                      75-2725998
  (State of incorporation)              (I.R.S. employer identification number)


        222 West Las Colinas Boulevard, Suite 450, Irving, Texas 75039
              (Address of principal executive offices) (Zip Code)

      Registrant's Telephone Number, Including Area Code: (972) 869-0770

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

                                     None

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

                    Common Stock, Par Value $.001 Per Share
                        Preferred Stock Purchase Rights


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

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

   Aggregate market value of Common Stock held by non-affiliates as of June 27,
2001: $23,789,112

   Number of shares of Common Stock outstanding as of June 27, 2001: 36,043,550

                      DOCUMENTS INCORPORATED BY REFERENCE

   Listed below are documents parts of which are incorporated herein by
reference and the part of this report into which the document is incorporated:


   (1)    Proxy statement for the 2001 annual meeting of shareholders - Part III
<PAGE>

                               TABLE OF CONTENTS

<TABLE>
----------------------------------------------------------------------------------------------------------------
<S>                                                                                                      <C>
PART          ITEM 1.  BUSINESS.........................................................................  2
 I            ITEM 2.  PROPERTIES.......................................................................  8
              ITEM 3.  LEGAL PROCEEDINGS................................................................  9
              ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
                       EXECUTIVE OFFICERS OF THE REGISTRANT.............................................  9
----------------------------------------------------------------------------------------------------------------
PART          ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
 II                    MATTERS.......................................................................... 11
              ITEM 6.  SELECTED FINANCIAL DATA.......................................................... 12
              ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                       OPERATIONS....................................................................... 13

                       RISK FACTORS..................................................................... 20
              ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES
                       ABOUT MARKET RISK................................................................ 32

              ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...................................... 32
              ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
                       DISCLOSURE....................................................................... 32
----------------------------------------------------------------------------------------------------------------
PART          ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............................... 33
III           ITEM 11  EXECUTIVE COMPENSATION........................................................... 33
              ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT................... 33
              ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS .................................. 33
----------------------------------------------------------------------------------------------------------------
PART          ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
 IV                    ON FORM 8-K...................................................................... 33
              SIGNATURES................................................................................ 36
</TABLE>
<PAGE>

                                   FORM 10-K

     The statements contained in this report that are not historical facts are
"forward-looking statements" (as such term is defined in Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934).
Forward-looking statements are typically identified by the use of terms such as
"may," "will," "expect," "intend," "anticipate," "estimate" and similar words,
or by discussions of strategy that involve risks and uncertainties, although
some forward-looking statements are expressed differently. You should be aware
that our actual results could differ materially from those contained in the
forward-looking statements due to a number of factors, including without
limitation, changes in external competitive market factors, changes in our
business strategy or an inability to execute our strategy, changes in the
hosting industry, changes in the economy in general and changes in the use of
the Internet, the demand for our services and the viability of Internet-based
businesses.  We cannot guarantee future results, levels of activity, performance
or achievements. Our actual results could differ materially from those
anticipated in forward-looking statements as a result of certain factors,
including those set forth in the section of this report entitled "Risk Factors."
Readers are cautioned not to place undue reliance on any forward-looking
statements contained in this report. All written and oral forward-looking
statements made in connection with this report that are attributable to us or
persons acting on our behalf are expressly qualified in their entirety by the
"Risk Factors" and other cautionary statements included herein. We disclaim any
obligation to update information contained in any forward-looking statement. We
undertake no obligation to publish the results of any adjustments to these
forward-looking statements that may be made to reflect events on or after the
date of this report or to reflect the occurrence of unexpected events.

                                    PART I

ITEM 1.   BUSINESS

Our Company

     Data Return provides advanced managed hosting services based on Microsoft
technologies. We provide these services to businesses seeking to outsource the
deployment, maintenance and support of their complex web sites. Our services
include providing, configuring, operating and maintaining the hardware, software
and network technologies necessary to implement and support these web sites.
We also offer additional services options, such as scalability and architecture
testing, storage solutions and a suite of security services, including
firewalls.

     Data Return was incorporated in August 1997 by three former Microsoft
product support engineers, and, as of March 31, 2001, hosted applications for
approximately 800 customers across many industries. Our customers range in size
from large Fortune 500 companies to smaller businesses, both conventional and
web-based. Our customers include Compaq, H&R Block, Microsoft, RadioShack.com,
Texas Instruments and The World Bank. Our advanced hosting services are designed
for customers deploying sophisticated, high-end Internet applications that
require a professionally-managed environment incorporating high performance
network access, advanced system monitoring and technical support in secure,
fault-tolerant facilities.

     Microsoft Corporation, Compaq Computer Corporation and Level 3
Communications, Inc. have invested in our company. We believe our relationships
with these companies enhance our credibility with potential customers and
provide us with early access to new products, superior technical services,
training and new business opportunities.

Our Solution

     Data Return is an advanced hosting provider dedicated to delivering
scalable, reliable and high performance hosting services on the Microsoft
platform. By combining our experience in managing Microsoft-based Internet
technologies, a scalable deployment architecture and high performance content
delivery, we have developed a family of services designed to address a wide
range of customer needs.

   Advanced Managed Services

     Managing the deployment of business-critical web applications requires an
in-depth understanding of the underlying software, hardware and network
technologies. We use our expertise in Microsoft technologies to provide
management services for our customers' hosting needs, including:

      .   recommendations on standardized system architecture;

                                       2
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      .   installation, configuration and stress testing of hardware and
          software;

      .   ongoing maintenance of hardware and software, including content back-
          ups and system upgrades;

      .   a broad array of system and network monitoring and reporting services;
          and

      .   technical support designed to respond to both simple and complex
          system issues.

   Scalable Deployment Architecture

     Our customers require system architecture that is flexible and can be
expanded to meet increasing demand. We offer scalable deployment architecture
for the Microsoft platform that enables customers to migrate to more robust
service offerings, such as high-end multi-server clustered solutions and
clustering across multiple data centers, as their site traffic grows. The
flexibility of this architecture allows us to offer a wide range of hosting
solutions to our customers.

   High Performance Content Delivery

     Overall application performance is an essential component to deploying an
Internet-based application successfully. There are many factors that contribute
to overall performance including the configuration and architecture for
hardware, software and Internet access. Our private networking architecture
bypasses the congested public exchange points, such as the Metropolitan Area
Exchanges and Network Access Points, increasing speed and reliability.

   Pre-Packaged Solutions for Advanced Hosting

     We have standardized our services into packages with defined pricing and
feature sets that can be used stand-alone or as components in a larger solution.
These solutions include hardware, maintenance and network connectivity.  We
believe these pre-packaged solutions provide a more complete alternative than
colocation. Colocation arrangements typically involve a vendor supplying space
for the server and Internet connections and some level of professional services,
often on an hourly basis.  With colocation, the customer is usually responsible
for defining and implementing the deployment architecture. Our pre-packaged
solutions enable our customers to outsource these responsibilities to us for
their Internet, extranet or intranet applications.

Our Services

     We package our hosting services into standardized, definable product
offerings that we believe include features desired by a wide range of customers
from Fortune 2000 companies to smaller, web-focused businesses. Our services are
designed to be comprehensive in terms of feature sets and to address our
customers' outsourcing needs for a wide variety of requirements, including:

     .    customers accessing public web sites on the Internet;

     .    employees accessing private web sites through intranets; and

     .    partners and other designated user groups accessing private or public
          web sites through extranets.

   Offerings

     Our advanced Microsoft hosting services allow us to support the Internet,
intranets and extranets for both commercially developed applications and custom-
developed applications. To address this wide variety of customer requirements,
we have developed three distinct categories within our service family -
clustered, dedicated and shared. We also offer a variety of additional services
such as firewalls and other security services, private circuits, data storage
offerings, and a scalability center that includes architecture, testing and
stress labs. We also offer just the managed services portion of our hosting
solution to some of our customers. Under these arrangements, we provide the
monitoring, maintenance and management of the infrastructure and the customer
provides its own servers, colocation and bandwidth. We can also provide these
services from the data centers of other providers or in

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our customers' data centers. For example, we are currently providing managed
services for customers in Exodus and AboveNet facilities. Because it leverages
our expertise in Microsoft technologies we believe that this offering is a
natural extension of our traditional hosting services.

       Clustered Hosting Services. For customers that deploy e-commerce enabled
     or other business-critical applications and expect high traffic volumes or
     require a high level of availability for their applications, we have
     developed a family of clustered hosting services, including multi-site
     clusters. Our clustered service plans distribute content and functionality
     across multiple servers or, in the case of multi-site clusters, across
     multiple data centers. This technology allows our customers' applications
     to scale beyond a single server or data center. Additionally, our
     clustering services are designed to allow our customers' business-critical
     applications to continue operating in the event a server fails. These
     services are designed to provide enhanced system performance and system
     reliability for application and database services.

       Dedicated Hosting Services. Dedicated hosting services are designed for
     customers with complex requirements and high traffic volumes who are
     seeking greater control over the server environment but who do not require
     clustered servers. Our dedicated service plans provide each customer with
     its own server. These service plans offer a number of advantages over
     shared hosting packages, including:

       .  improved service reliability and content delivery by limiting each
          server to a single developer environment; and

       .  greater flexibility in configuration of the specific server
          environment.

     We offer several dedicated service options that range from entry-level web
     servers to high performance, multi-processor database servers.

       Shared Hosting Services. Shared hosting services, our entry level service
     plan, are for customers with relatively low volumes of traffic. We have
     designed our shared hosting package to minimize the cost for customers by
     providing these services on a server shared by multiple customers. This
     service plan includes many standard features and options for database
     support, commerce support and media services.

Customers

     We typically provide hosting services directly to end user customers, both
traditional enterprises and internet-focused businesses.  However, we also
provide hosting services to application service providers, web site development
firms and other organizations that bundle our solution with a service or product
they provide to their end user customers. Our customers are located primarily in
North America and Europe. As of March 31, 2001, we hosted  applications for
approximately 800 customers ranging from Fortune 500 companies and small- and
medium-sized businesses to start-up businesses, including Internet-focused
businesses. Our top customers based on their monthly recurring revenue at the
end of fiscal 2001 include:


     Goldpocket Interactive             Texas Instruments
     H & R Block                        Compaq
     Microsoft                          Opus-i
     Radio Shack                        InformIT.com
     Denguri                            Codigent.com
     Houston Street Exchange            Fallon Interactive (bmwusa.com and
     Americredit                        bmwfilms.com)
     Portum Gmbh                        Global Risk Exchange
                                        iVita Corporation


     During fiscal 2001, Goldpocket Interactive, Inc. accounted for 18% of
revenue. Our results of operations will be adversely affected if we lose the
revenues we expect to be generated by this customer. No other customer accounted
for 10% or more of revenue during fiscal 2001, 2000 or 1999.

                                       4
<PAGE>

Key Relationships

   Level 3

     We entered into a five-year relationship with Level 3 in July 1999. This
strategic relationship allows us to leverage our advanced hosting and managed
application services with their U.S. data center infrastructure. We have agreed
that if Level 3 can provide substantially similar services to those we request
we will purchase 90% of these services from Level 3 through June 2004. We route
the network traffic of our customers through multiple backbone providers to
increase network performance. To enable us to do this, we obtain Internet
connectivity through a number of providers, and Level 3 may not be able to
provide all of the connectivity services that we require. As a result, we may
purchase less than the applicable percentages of these services from Level 3.
Under our agreement with Level 3, we are required to purchase at least an
additional $8.3 million of bandwidth and colocation services over the next four
years.  Our quarterly commitment is $300,000 per quarter through July 2001,
$400,000 per quarter during the next 12 months, $600,000 per quarter during the
next 12 months and $1.0 million per quarter during the final 12 months of the
agreement. During fiscal 2001, we exceeded our purchase commitment to Level 3.
The prices we will pay Level 3 for the services over the term of our agreement
are based upon Level 3's then-current prices to other companies purchasing
similar quantities. Level 3 can terminate our agreement if we default and do not
cure the default within 30 days of notice or upon a change of control that
results in Data Return being owned by a competitor of Level 3. Level 3 has
acquired 1,952,940 shares of our common stock in exchange for $5.0 million in
credit for future bandwidth purchases in excess of our quarterly purchase
commitment.   During the fourth quarter of fiscal 2001, the first quarter in
which we were eligible to utilize this credit, we utilized $406,000 of the
credit.

   Compaq

     We use Compaq servers to provide the hardware platform for our advanced
hosting services. Our relationship with Compaq provides direct contact with
product development engineers and management at multiple levels within the
Compaq organization. In July 1999, we entered into a three-year agreement with
Compaq under which we agreed to purchase from Compaq the lesser of 2,000 servers
or the number of servers reasonably necessary to adequately operate our business
consistent with our business plan. We are required to purchase these servers
only if Compaq provides financing for the servers on competitive terms, if the
price, performance and quality of the Compaq servers is reasonably satisfactory
to us and if Compaq commits to deliver these servers on the schedule we request.
Through March 31, 2001, we had purchased approximately 1,800 servers under this
agreement.  Compaq also owns 1,171,764 shares of our common stock.

   Microsoft

     In September 1999, we entered into a development, license and co-marketing
agreement with Microsoft. Under this agreement we licensed proprietary
installation tools for third-party hosted applications to Microsoft. Microsoft
owns 454,546 shares of our common stock and a warrant to acquire an additional
340,910 shares of our common stock at an exercise price of $11 per share.

     We are recognized by Microsoft as one of the leading providers of advanced
hosting services on the Microsoft platform. We were named the Microsoft Windows
2000 Global Hosting Partner of the Year. We believe that one of our key
competitive advantages is the level of customer service and support that we can
provide as a result of our relationship. However, except for our relationship
with Microsoft under this development, license and co-marketing agreement, we do
not have an agreement with Microsoft to continue our relationship, and Microsoft
could discontinue its relationship with us at any time.

Marketing and Sales

     Our marketing efforts are primarily focused on building the Data Return
brand while generating demand for our services. We devote most of our marketing
resources to direct mail and telemarketing targeted at Information Technology
decision-makers and advertising in magazines targeted at developers and
information service professionals. We also advertise online and exhibit at trade
shows and conferences.

     Our sales force included 25 quota-bearing sales representatives at March
31, 2001. Each outside salesperson's territory included one or more Level 3 U.S.
gateways. We intend to continue to expand our sales force.

                                       5
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Customer Support

     We believe a critical element of customer service is providing a high level
of technical expertise within both customer support and systems organizations.
Our technical support engineers are expected to be proficient in at least:

      .   one major network operating system;

      .   two applications from our supported product list; and

      .   either one programming language or one database application.

     All systems are monitored and maintained on a 24 hours a day, seven days a
week, or 24x7, basis. We provide business-critical customer support on a 24x7
basis.  We also provide customer support for other issues from 9AM-8PM Central
time Monday through Friday and 9PM-6PM Saturday and Sunday via both telephone
and electronic request forms. Response times are published on our support web
site and are prioritized according to severity levels.   We have also created
dedicated support teams that are available on a 24x7 basis to customers with
especially complex deployments.  These dedicated support teams provide a direct
line of communication for our customers, which we believe provides a superior
level of service.

     We also have developed a web-based customer care application, called the
Customer Service Center, or CSC.  Customers can access specific information
about their application through the CSC, including application availability and
performance, incident histories, account balances and payment histories and
scheduled maintenance.  Customers can also use the CSC to notify us of upcoming
events or changes to their configuration.

Infrastructure

     We use a platform that is comprised mostly of Internet-related software
products running on Microsoft's Windows 2000 and NT operating systems and Compaq
servers. We primarily use F5 clustering switches and load balancers along with
Cisco switches and routers to connect our servers to the Internet. By focusing
on standard platforms, we gain efficiency and effectiveness in terms of
training, documentation, spare parts and overall support. We also maintain some
hosting services running on other software platforms. In addition, we support
application level services such as BizTalk, SQL Server, Application Center,
Active Server Pages and Commerce Server. Specifically, our infrastructure
consists of the following key elements:

      .   secure, carrier-class data centers;

      .   a scalable server platform;

      .   automated deployment processes;

      .   monitoring and systems management; and

      .   advanced high performance network.

   Secure, Carrier-Class Data Centers

     Our primary data center is located within Level 3's Dallas gateway.
Security for the data center is provided with a guard and entry restriction via
access device. Power to the building is provided by redundant connections from
separate transformers. The data center is also equipped with fire suppressant
systems, environmental control systems and redundant networking hardware. The
Level 3 facility provides us with access to Level 3's worldwide IP network. We
also offer hosting services from other Level 3 gateways and provide managed
services to customers in data centers of other providers. During fiscal 2001, we
expanded our presence to Level 3 gateways in New York and London.

                                       6
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   A Scalable Server Platform

     Our standard platform for service delivery uses Compaq servers. These
servers generally run the Windows 2000 or NT operating system along with various
application software, such as Microsoft SQL Server or Microsoft Internet
Information Server. Compaq's Distributed Internet Server Array (DISA)
architecture leverages the clustering and load balancing features of the Windows
2000 or Windows NT server platforms. This architecture enables us to support
scalable, highly-available Internet-enabled applications. In addition, by
focusing on standard platforms, we believe that we can gain efficiency and
effectiveness in terms of training, documentation, spare parts and overall
support.

   Automated Deployment Processes

     We configure and test our hardware and software through the use of both
commercially available and internally built tools. The software installation
process consists of a series of unattended scripts and batch files providing a
fast, consistent and repeatable configuration. As the server is provisioned with
user accounts, web sites and file transfer protocol sites, the automated script
also tests each step to evaluate whether the server is functioning correctly. We
also manually test the installation process to further evaluate the quality and
integrity of the installation.

   Monitoring and Systems Management

     We combine commercial tools and internally built applications to provide
monitoring, analysis and reporting of application, service and hardware
performance on a 24x7 basis. Systems administration and management is remotely
performed using an interface that encrypts all client-server communication with
an encryption algorithm for added security. Additionally, we offer a customer
control panel, which provides a standard user interface that allows customers to
perform the most commonly performed web site administrative tasks. The customer
control panel also allows customers to electronically submit more advanced
administrative tasks and support requests to our service and support group.

   Advanced High Performance Network

     We have based our network hardware on Cisco and F5 technologies. Our
network consists of multiple, diverse connections to the Internet that currently
provide us with local access to multiple leading backbone providers. These
multiple connections allow us to increase both performance and reliability by
routing traffic over private connections to bypass congested public exchange
points such as the Metropolitan Area Exchanges and Network Access Points. In
addition to increased performance, our network architecture reduces our
dependency on any one network provider, increasing network availability for our
customers. Our network security solutions include firewalls, encryption
techniques, virtual private networks and other security technologies and
techniques.

Competition

     The markets in which we operate are highly competitive, and competition is
increasing because few apparent substantial barriers to entry exist in the
Internet hosting market. Although it is impossible to quantify our relative
competitive position in our market, many of our competitors have substantially
greater financial, technical and marketing resources, larger customer bases,
longer operating histories, greater name recognition and more established
relationships in the industry than we have. We expect that we will face
competition from existing competitors as well as new market entrants in the
future. The primary competitive factors in our market are:

      .   technical expertise in developing and delivering advanced hosting
          solutions;

      .   quality of service, including network capability, scalability,
          reliability and functionality;

      .   customer service;

      .   number and quality of sales personnel;

      .   variety of services and products offered;

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      .   price;

      .   brand name recognition;

      .   Internet system engineering and technical expertise;

      .   timing of introductions of value-added services and products;

      .   network security;

      .   relationships with partners; and

      .   financial resources.

     Our current and potential competitors vary by size, product offering and
geographic region and may elect to partner with each other or with focused
companies like us to deliver service on the Microsoft platform. They include:

      .   Microsoft advanced hosting providers;

      .   web and application hosting service providers;

      .   application-specific hosting service providers;

      .   colocation providers;

      .   managed service providers;

      .   local, regional and international Internet service providers;

      .   local, regional and international telecommunications companies;

      .   systems integrators and large information technology outsourcing
          companies;

      .   multimedia hosting companies; and

      .   other hardware, software and technology companies.

     Our competitors may operate in one or more of these areas and include
companies such as AboveNet, AT&T, British Telecommunications, Cable & Wireless,
Concentric Network, Critical Path, Dell, Digex, Exodus Communications,
Frontier/GlobalCenter, Globix, GTE, Genuity, IBM, Intel, Interliant, Level 3,
Loudcloud, MCI WorldCom (including UUNET), Navisite, PSINet, Qwest
Communications International, Usinternetworking, USWeb/CKS Group, Verio and
Yahoo!

Employees

     As of March 31, 2001, we had 531 employees (see "Part II, Item 4,
Management's Discussion and Analysis of Financial Condition and Results of
Operations -Recent Developments"). None of our employees are covered by
collective bargaining agreements. We believe that our relations with our
employees are good.

2.   PROPERTIES

     Our corporate headquarters are currently located in Irving, Texas and
consist of approximately 168,438 square feet of office space of which the
majority is leased until May 31, 2003 with the remaining space expiring May 31,
2006. We also have an office in Dallas, Texas, consisting of 10,500 square feet
of office space that is leased until May 31, 2004.

                                       8
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ITEM 3.   LEGAL PROCEEDINGS

     We do not believe that we are subject to any pending or threatened legal
proceedings.

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

     Not applicable.

EXECUTIVE OFFICERS OF THE REGISTRANT

The following sets forth information regarding our executive officers:

<TABLE>
<CAPTION>
     Name                                          Age                              Position
 --------------                                    ---                        ----------------------
<S>                                                <C>     <C>
Sunny C. Vanderbeck............................... 28      Chairman of the Board and Chief Executive Officer
Michelle R. Chambers.............................. 32      President and Director
Robert A. Prosen.................................. 46      Chief Operating Officer
Michael S. Shiff.................................. 47      Executive Vice President
Kenneth S. Garber................................. 47      Senior Vice President - Marketing, Sales and Business
                                                           Development
Alonso M. Perales................................. 45      Senior Vice President - Operations
J. Todd Steitle................................... 35      Senior Vice President  - Product Development
Stuart A. Walker.................................. 36      Senior Vice President  - Chief Financial Officer and
                                                           Treasurer
</TABLE>

     Sunny C. Vanderbeck, a co-founder of the Company, has served as Chairman
and Chief Executive Officer since our incorporation in August 1997. Before
founding Data Return, from July 1996 to January 1997, Mr. Vanderbeck was a
technical product manager and Lead Internet/Intranet Consultant for Software
Spectrum, a reseller of Microsoft products. From May 1995 to June 1996, while
employed by Software Spectrum, Mr. Vanderbeck served as an independent
consultant to Microsoft where he served as a team leader for Microsoft Messaging
products and as a product support engineer. From July 1994 to May 1995, Mr.
Vanderbeck was an independent consultant. From 1990 to 1994, Mr. Vanderbeck
served as a Section Leader in the 2nd Ranger Battalion, a U.S. Army Special
Operations unit.

     Michelle R. Chambers, a co-founder of the Company, has served as President
and a director since our inception and served as Chief Operating Officer from
April 1998 until March 2001. Before founding Data Return, from October 1996 to
March 1997, Ms. Chambers was a Consultant at Microsoft, where she was a member
of the Microsoft Consulting team responsible for the design and development of
the migration plan for Audionet's (now Yahoo! Broadcast) platform conversion
from Unix to Windows NT. Prior thereto, Ms. Chambers served as a product support
engineer at Microsoft from February 1995 to October 1996, and was the Corporate
E-mail Coordinator for Arco Exploration and Production Technology from August
1993 to February 1995. Ms. Chambers is a Microsoft Certified Systems Engineer.

     Robert A. Prosen has served as Chief Operating Officer since March 2001 and
served as Senior Vice President - Operations from May 2000 until March 2001.
Prior to joining Data Return, Mr. Prosen served as Senior Vice President of
Sabre Technology Solutions, from 1997 to May 2000 where he led the Americas
Region to become Sabre's top performing business unit. Before joining The Sabre
Group, Mr. Prosen was Vice President of Professional Services at Hitachi Data
Systems from 1995 to 1997, where he planned and directed business operations and
technology planning, as well as network and year 2000 consulting. Prior to this,
from 1993 to 1995, he served as managing partner of Professional Services for
AT&T Global Information Solutions (currently NCR). His accomplishments at AT&T
include building a nationally recognized management and technology consulting
practice that offered services such as network and architecture consulting,
program management, solutions engineering, and systems integration. Mr. Prosen
also held various management positions with AT&T and Sprint in operations,
sales, human resources, engineering, customer service, information systems and
financial planning.

     Michael S. Shiff has served as Executive Vice President since April 2001
and served as Senior Vice President - Marketing, Sales and Business Development
from June 1999 to April 2001. Mr. Shiff also previously served as Vice
President - Marketing, Sales and Business Development from March 1998 to June
1999. Mr. Shiff served as

                                       9
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President of MicroVision Medical Systems, a manufacturer of medical imaging
systems, from April 1996 to December 1996. From April 1993 to November 1995, Mr.
Shiff was Vice President of Sales for Kodak Health Imaging Systems, a
manufacturer of medical imaging systems. He also served as Vice President of
Marketing and Sales for Vortech Data, a manufacturer of medical imaging systems,
from March 1989 until Vortech's acquisition by Eastman Kodak in March 1993.
Prior thereto, Mr. Shiff was Director of Strategic Sales Development for Hughes
Network Systems, a manufacturer of telecommunications systems, and was Domestic
Marketing Manager for the Satellite Communications Group of M/A-COM
Telecommunications, a manufacturer of telecommunications systems, which was
acquired by Hughes Aircraft.

     Kenneth S. Garber has served as served as Senior Vice President -Marketing,
Sales and Business Development since April 2001 and prior to that served as Vice
President - Worldwide Sales from October 2000. Mr. Garber also served as Vice
President Sales from June 1999 to October 2000. From March 1996 to May 1999, Mr.
Garber was Vice President of Sales and Business Development for Chroma Vision
Medical Systems, Inc., a manufacturer of medical imaging systems. Prior to that,
Mr. Garber served as Vice President and General Manager of the Imagelink
Business Unit for Kodak Health Imaging Systems from 1994 to March 1996.
Previously, Mr. Garber held various marketing and sales positions with Vortech
Data, Hughes Network Systems, Satellite Business Systems and Federal Data
Corporation.

     Alonso M. Perales has been Senior Vice President - Operations since March
2001 and served as Vice President - Service and Support from December 2000 until
March 2001. Mr. Perales joined Data Return from Microsoft Corporation, where for
the previous five years he had directed product support services for the Central
United States, Canada, Latin America and the South Pacific regions. Prior to his
tenure with Microsoft, Mr. Perales was a principal in Expert Business Systems, a
software development and consulting company. Mr. Perales also spent 12 years in
various management roles with IBM.

     J. Todd Steitle has served as served as Senior Vice President - Product
Development since March 2001 and served as Vice President - Marketing
Communications from June 1999 to March 2001. Previously, he served as our
Director of Marketing from May 1998 to June 1999. Before joining Data Return,
Mr. Steitle held various sales and marketing positions for the Tools Division of
Sybase Corporation, formerly Powersoft Corporation, a software company, from May
1996 to May 1998. From September 1994 to May 1996, Mr. Steitle served as Manager
of Business Development for Kodak Health Imaging Systems. Previously, Mr.
Steitle held various marketing and sales positions for Apple Computer
Corporation.

     Stuart A. Walker has served as our Senior Vice President - Chief Financial
Officer and Treasurer since May 2000 and previously served as Vice President -
Chief Financial Officer and Treasurer since June 1999 and as Chief Financial
Officer since March 1999. He also served as Secretary from June 1999 until
November 1999. Prior to joining Data Return, Mr. Walker was a consultant with
Eubank, Wofford and Nichols, LLP, a public accounting firm, from June 1998. Mr.
Walker served as Vice President and Chief Financial Officer of Aviation Group,
Inc., an aviation services company, from September 1997 to April 1998. He served
as Corporate Controller of Precept Business Products, Inc., a business products
distribution company, from August 1996 to August 1997. He was Vice President
Finance and Controller of DirectNet Corporation, an educational technology
company, from March 1995 to August 1996.

                                       10
<PAGE>

                                    PART II

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

  Our common stock is traded on the Nasdaq National Market under the symbol
"DRTN." The following table sets forth the range of the high and low closing
sale prices of our common stock by quarter as reported on the Nasdaq National
Market since October 27, 1999, the date our common stock commenced trading.


Quarter                         High               Low
--------------------------------------------------------------------------------

Year Ending March 31, 2001:
      Fourth Quarter           $ 9.81             $ 2.56
      Third Quarter            $19.94             $ 3.38
      Second Quarter           $37.75             $15.50
      First Quarter            $41.63             $13.25

Year Ending March 31, 2000:
      Fourth Quarter           $94.25             $36.50
      Third Quarter            $67.13             $13.75


   As of June 27, 2001, we had 100 shareholders of record. Because many of our
shares are held by brokers and other institutions on behalf of shareholders, we
are unable to estimate the total number of beneficial shareholders represented
by these record holders.

   We have never declared or paid any cash dividends on our stock. We currently
intend to retain any earnings for use in our business and do not anticipate
paying any cash dividends in the foreseeable future.

                                       11
<PAGE>

ITEM 6.  SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                           Years ended March 31,                     Period From
                                                           ---------------------
                                                                                                    September 22,
                                                                                                        1997
                                                                                                   (inception) to
                                                   2001            2000             1999           March 31, 1998
                                                   ----            ----             ----           --------------
                                                                   (dollars in thousands)
<S>                                              <C>             <C>               <C>            <C>
Statements of Operations Data:
Revenues.......................................  $ 50,068        $ 11,833          $ 1,889            $   336
Costs and expenses:
  Cost of revenue..............................    45,444           9,277            1,105                198
  General and administrative...................    23,418           7,575            1,061                230
  Marketing and sales..........................    24,492           6,212              663                 39
  Product research and development.............     4,778             548                2                  0
  Stock-based compensation.....................       171           1,779              349                 61
                                                 --------        --------          -------            -------
Total costs and expenses.......................    98,303          25,391            3,180                528
                                                 --------        --------          -------            -------
Loss from operations...........................   (48,235)        (13,558)          (1,291)              (192)
Other income, net..............................     1,083           1,870                7                  2
                                                 --------        --------          -------            -------
Loss before cumulative effect of change in
accounting principle...........................  $(47,152)       $(11,688)         $(1,284)           $  (190)
Cumulative effect of change in accounting
principle......................................  $ (1,626)       $      0          $     0            $     0
                                                 --------        --------          -------            -------
Net loss.......................................  $(48,778)       $(11,688)         $(1,284)           $  (190)
                                                 ========        ========          =======            =======
Net loss per common share before
cumulative effect of change in accounting
principle......................................  $  (1.32)       $  (0.40)         $ (0.07)           $ (0.01)
                                                 ========        ========          =======            =======
Net loss per common share after................
cumulative effect of change in accounting
principle......................................  $  (1.37)       $  (0.40)         $ (0.07)           $ (0.01)
                                                 ========        ========          =======            =======
Shares used in per share computation...........    35,712          29,268           18,371             15,882
                                                 ========        ========          =======            =======
Other Financial Data:
EBITDA (1).....................................  $(32,548)       $ (9,565)         $  (813)           $  (118)
Net cash used in operating
 Activities....................................   (29,105)         (8,955)            (645)                 2
Net cash used in investing activities..........   (40,215)         (5,828)            (939)               (55)
Net cash (used in) provided by financing
activities.....................................    (9,538)         99,364            1,953                527
Purchases of property and equipment............    13,415           5,953              814                 55
</TABLE>

<TABLE>
<CAPTION>
                                                                                       March 31,
                                                                                       --------
                                                                        2001        2000        1999       1998
                                                                        ----        ----        ----       ----
                                                                                 (dollars in thousands)
<S>                                                                  <C>        <C>           <C>         <C>
Balance Sheet Data:
Working capital................................................      $17,734    $ 79,970      $  561      $ 321
Total assets...................................................       87,632     114,857       2,214        734
Notes payable and capital lease obligations--long-term.........       18,173      11,324         166         36
Total shareholders' equity.....................................       44,161      91,301       1,245        430
</TABLE>

(1) EBITDA consists of loss from operations of $48,235,000, $13,558,000 and
    $1,291,000 plus depreciation and amortization of $15,516,000, $2,214,000 and
    $129,000 plus amortization of unearned stock-based compensation of $171,000,
    $1,779,000 and $349,000 for the years ended March 31, 2001, 2000 and 1999,
    respectively. EBITDA does not represent funds available for management's
    discretionary use and is not intended to represent cash flow from operations
    as measured under generally accepted accounting principles.

                                       12
<PAGE>

     EBITDA should not be considered as an alternative to net loss or net cash
     used in operating activities, but may be useful to investors as an
     indication of operating performance. Our calculations of EBITDA may not be
     consistent with calculations of EBITDA used by other companies.

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

     You should read the following discussion together with the financial
statements and other financial information included in this Annual Report on
Form 10-K. This report contains forward-looking statements that involve risks
and uncertainties. Our actual results may differ materially from those projected
in the forward-looking statements. Our fiscal year ends on March 31.

Overview

     Data Return provides advanced Internet hosting services based on Microsoft
technologies. We provide these services to businesses seeking to outsource the
deployment, maintenance and support of their complex web sites. Our services
include providing, configuring, operating and maintaining the hardware, software
and network technologies necessary to implement and support these web sites.

     Our business and the industry in which we operate are rapidly evolving, and
we have a limited operating history. As a result, we believe that period-to-
period comparisons of our revenue and operating results, including our cost of
revenue and other operating expenses as a percentage of total revenue, may not
be meaningful and should not be relied upon as indicators of future performance.
We do not believe that our historical growth rates, particularly the high rates
of growth we experienced in previous quarters, are indicative of future results.

     Currently, we derive substantially all of our revenue from hosting and
managed services. This includes revenue from our dedicated server offerings,
including clustered servers, and our shared server offering. With our dedicated
server offerings, each server is dedicated to providing service to one customer.
In a clustered configuration, we utilize two or more dedicated servers to
distribute content and functionality across multiple servers or, in the case of
multi-site clusters, across multiple data centers. Hosting and managed services
revenue also includes shared hosting, in which more than one customer shares the
same server. Historically, we have also derived a nominal amount of revenue from
technical reviews and the resale of software and other products. Currently, most
of our advanced hosting and managed services revenues are generated from
recurring monthly fees. Substantially all of the remainder is derived from one-
time set-up fees for installation and from sales of services, such as time and
materials billing and certain lab or consulting services.

     Services are billed on a monthly basis and, except as described below, are
recognized as the service is performed. As a result of our adoption of Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements ("SAB
101"), revenues from set-up, or installation, services are recognized over the
initial term of the customer contract. See "- Recent Accounting Pronouncements"
for a description of our adoption and the effect of SAB 101 and "Results of
Operations - Comparison of fiscal 2001 and 2000 - Cumulative effect of change in
accounting principle" and "Results of Operations - Comparison of fiscal 2001 and
2000 - Cumulative effect of change in accounting principle" for a discussion of
the effect of this change in accounting principle during fiscal 2001.

     Our expenses are comprised of:

     .  cost of revenue, which consists primarily of compensation and related
        expenses for technical operations, broadband services expenses, space in
        data centers and depreciation of equipment;

     .  general and administrative, which consists primarily of compensation and
        related expenses and occupancy costs;

     .  marketing and sales, which consists primarily of compensation and
        related expenses, advertising expenses and occupancy costs;

                                       13
<PAGE>

     .  product research and development, which consists primarily of
        compensation and related expenses and occupancy costs; and

     .  stock-based compensation, which relates to employee stock options
        granted at prices less than fair value.

     We have incurred significant losses since our inception and, as of March
31, 2001, had an accumulated deficit of approximately $61.7 million. We intend
to continue to invest in marketing and sales and the continued development of
our network infrastructure and technology. We expect to continue to expand our
operations and workforce, primarily in the sales and marketing areas. We expect
to continue to incur substantial losses for the foreseeable future. We may not
be able to successfully execute our expansion plans.

Recent Developments

     On May 11, 2001, we reduced our workforce by 94 employees. The reduction in
workforce was a result of slower than anticipated growth and increased process
and other operational efficiencies.  As a result of this workforce reduction, we
anticipate a one-time restructuring charge of $1.0 million to $1.5 million in
the first quarter of fiscal 2002. Giving effect to this reduction, on May 12,
2001, our employee base consisted of the following: 194 in systems operations
and service and support, 90 in general and administrative functions, 110 in
marketing and sales and 49 in product research and development.

Results of Operations

     The following table sets forth selected financial data as a percent of
revenue for the fiscal years ended March 31, 2001, 2000 and 1999.

<TABLE>
<CAPTION>
                                                                             % of Revenue
                                                             ----------------------------------------------
                                                                           Year Ended March 31,
                                                                           --------------------
                                                                2001              2000              1999
                                                                ----              ----              ----
<S>                                                            <C>               <C>               <C>
Revenues...................................................    100.0%            100.0%            100.0%
Costs and expenses:
  Cost of revenue..........................................     90.8              78.4              58.5
  General and administrative...............................     46.8              64.0              56.2
  Marketing and sales......................................     48.9              52.5              35.1
  Product research and development.........................      9.5               4.6                .1
  Stock-based compensation.................................       .3              15.1              18.5
                                                               -----            ------             -----
Loss from operations.......................................    (96.3)           (114.6)            (68.4)
Other income (expense):
  Interest income..........................................      7.5              18.5               1.1
  Interest expense.........................................     (5.3)             (2.7)             (0.7)
                                                               -----            ------             -----
Loss before cumulative effect of change in
 accounting principle).....................................    (94.1)%           (98.8)%           (68.0)%
                                                               =====            ======             =====
Cumulative effect of change in accounting principle........    ( 3.3)%           (  .0)%           (  .0)%
                                                               =====            ======             =====
  Net loss.................................................    (97.4)%           (98.8)%           (68.0)%
                                                               =====            ======             =====
</TABLE>

Comparison of fiscal 2001 and 2000

Revenues

     Our revenues increased $38,235,000 to $50,068,000 for fiscal 2001 from
$11,833,000 for fiscal 2000. Dedicated hosting revenue increased $35,370,000 to
$41,839,000, or 83.6% of revenue, for fiscal 2001 from $6,469,000, or 54.7% of
revenue, for fiscal 2000. Shared hosting revenue increased $631,000 to
$2,911,000, or 5.8% of revenue, for fiscal 2001 from $2,280,000, or 19.3% of
revenue, for fiscal 2000. Set-up fees increased $1,072,000 to $3,722,000, or
7.4% of revenue, for fiscal 2001 from $2,650,000, or 22.4% of revenue, for
fiscal 2000. Revenues from testing and other lab services were $352,000 during
fiscal 2001 reflecting the opening of our

                                       14
<PAGE>

scalability lab in September 2000. The increase was primarily due to the
addition of new customers that generated higher average monthly revenues. Growth
from some existing customer accounts also contributed.

Cost of revenue

     Our cost of revenue increased $36,167,000 to $45,444,000, or 90.8% of
revenue, for fiscal 2001 from $9,277,000, or 78.4% of revenue, for fiscal 2000.
The increase in cost of revenue was due primarily to increases in personnel and
related costs, depreciation and amortization expenses, communication and
bandwidth expenses, other hardware and software equipment costs, facilities and
travel and professional services. Personnel and related expenses increased
approximately $15,408,000 to $20,439,000, or 40.8% of revenue, for fiscal 2001
from $5,031,000, or 42.5% of revenue, for fiscal 2000, as we increased our
systems operations and customer support personnel to 237 at March 31, 2001 from
167 at March 31, 2000. Depreciation and amortization expenses increased
approximately $10,574,000 to $12,250,000 for fiscal 2001, from $1,676,000 for
fiscal 2000, as we added approximately $23.5 million in computer and related
equipment since March 31, 2000. Our communication and bandwidth expenses
increased $6,772,000 to approximately $8,107,000 for fiscal 2001 from $1,335,000
for fiscal 2000 to support our increased business activities. Other hardware and
software equipment costs increased $1,194,000 to $1,695,000 for fiscal 2001 to
support the growth in our business. Facilities costs increased $1,159,000 to
$1,427,000 for fiscal 2001 due to a move into a larger facility in September
1999. Travel and professional services increased $207,000 and $309,000, to
$291,000 and $404,000, respectively, for fiscal 2001. We expect our cost of
revenue to continue to increase as our overall business grows.

General and administrative

     General and administrative expense increased $15,843,000 to $23,418,000, or
46.8% of revenue, during fiscal 2001 from $7,575,000, or 64.0% of revenue,
during fiscal 2000.  The increase is primarily due to increases in personnel and
related expenses, bad debt, depreciation, professional services, facilities,
supplies, insurance, travel, tax expense and amortization of warrants granted to
vendors. Personnel and related expenses increased $5,835,000 to $10,475,000, or
20.9% of revenue, for fiscal 2001 from $4,640,000, or 39.2% of revenue, for
fiscal 2000. We increased our number of employees in general and administrative
functions to 117 employees at March 31, 2001 from 89 employees at March 31,
2000.  Bad debt expense increased $3,020,000 to $3,547,000 as many of our
customers, particularly Internet-based businesses, ceased operations or reduced
or eliminated the web site operations hosted by us.  We expect our financial
results, including bad debt expense, to continue to be negatively impacted by
the termination or reduction in service from these businesses.  Depreciation
expense increased $1,416,000 to $1,801,000 for fiscal 2001, which is a result of
increased internal equipment necessary to support the growth of our business.
Professional services fees increased approximately $1,057,000 to $1,556,000 for
fiscal 2001 from $499,000 in the comparable period in 2000.  Expenses for
facilities, supplies, insurance and travel increased $1,852,000, $420,000,
$353,000 and $74,000, to $2,298,000, $561,000, $568,000 and $518,000,
respectively, for fiscal 2001 as a result of our move into a larger facility and
to support the growth in general and administrative employees.  Tax expense
increased to $403,000 for fiscal 2001 due to franchise and other state and local
taxes.  Amortization costs related to the warrants we issued to Microsoft in
September 1999 and Sicola Martin in March 2000 increased  $375,000 to $553,000
in fiscal 2001.

Marketing and sales

  Marketing and sales expense increased $18,280,000 to $24,492,000, or 48.9% of
revenue, during fiscal 2001 from $6,212,000, or 52.5% of revenue, during fiscal
2000. The increase was due primarily to an increase in marketing and sales
personnel and related expenses, advertising costs, including agency fees,
promotional items, printing and trade shows, travel, depreciation, and
facilities expenses.  Personnel and related expenses increased $10,168,000 to
$14,715,000, or 29.4% of revenue, for fiscal 2001 from $4,547,000, or 38.4% of
revenue, for fiscal 2000. Advertising costs increased $5,232,000 to $6,078,000
for fiscal 2001 from $846,000 for fiscal 2000. Costs in this category include
expenses for advertising, promotional items, printing, trade shows, and fees
paid to advertising, public relations and other creative agencies.  Travel
expenses increased $1,423,000 to $1,685,000 for fiscal 2001 as a result of the
growth in the marketing and sales personnel. Depreciation and facilities
expenses increased $732,000 and $657,000, to $732,000 and $781,000,
respectively, for fiscal 2001 due to our move into a larger facility.  We
increased our marketing and sales personnel to 114 at March 31, 2001 from 52 at
March 31, 2000.

                                       15
<PAGE>

Product research and development

     Product research and development expense increased $4,230,000 to
$4,778,000, or 9.5% of revenue, during fiscal 2001 from $548,000, or 4.6% of
revenue, during fiscal 2000. The increase was due primarily to an increase in
product research and development personnel and related expenses, facilities,
depreciation and travel expenses. Personnel and related expenses increased
$3,379,000 to $3,860,000, or 7.7% of revenue, for fiscal 2001 from $481,000, or
4.1% of revenue, for fiscal 2000. We increased our number of employees in
product research and development to 63 at March 31, 2001 from 17 at March 31,
2000. Facilities, depreciation and travel expenses increased $327,000, $178,000
and $87,000 to $346,000, $180,000 and $127,000, respectively, for fiscal 2001 as
a result of our move into a larger facility and the increase in the number of
product research and development employees.

Stock-based compensation

     Deferred stock compensation was recorded in connection with the grant of
employee stock options below fair value in 1998 and 1999. Amortization of stock-
based compensation totaled $171,000 for fiscal 2001 and $1,779,000 for fiscal
2000. The amortization of stock-based compensation is based on the vesting
schedule of stock options held by our employees.

Other income (expense)

     Other income (expense) consists primarily of interest income on our cash
balances and investments in marketable securities and interest expense on our
outstanding notes payable and capital lease obligations. Interest earned on our
cash and cash equivalents increased $1,558,000 to $3,749,000 for fiscal 2001
from $2,191,000 for fiscal 2000. This increase was due primarily to the closing
of our initial public offering in October 1999, which resulted in higher cash
balances available for investment for the majority of fiscal 2001. During fiscal
2001, interest expense increased $2,345,000 to $2,666,000 related primarily to
equipment acquired under capital leases during the last four quarters.

Income taxes

     No provision for federal income taxes has been recorded as we have incurred
net operating losses since our inception. We have recorded a full valuation
allowance against our net deferred tax asset, which is primarily attributable to
net operating loss carry forwards, due to uncertainty that we will generate
sufficient taxable income during the carry forward period to realize the benefit
of our net deferred tax asset.

Cumulative effect of change in accounting principle

     Effective April 1, 2000, we changed our method of accounting for set-up
fees in accordance with SAB 101. The net effect on fiscal 2001 of the change in
accounting principle was to reduce our net loss by $408,000. We recognized set
up revenues of $3.7 million under the new method of revenue recognition,
including the $1.6 million cumulative adjustment that was recorded as of April
1, 2000 and amortized into income in fiscal 2001. We would have recognized $3.3
million in set up revenue under the prior method. With the adoption of SAB 101,
there was no impact on our operations or cash flow. See "- Recent Accounting
Pronouncements" for a description of our adoption and the effect of SAB 101.

Net loss

     Net loss increased to $48,778,000 for fiscal 2001 from $11,688,000 for
fiscal 2000. As more fully discussed above, the increased net loss is primarily
attributable to increased costs as we continued to build our business for
anticipated growth.

EBITDA

     EBITDA, as defined below, decreased $23,012,000 to negative $32,548,000 for
fiscal 2001 from negative $9,565,000 for fiscal 2000.  The decrease is primarily
attributable to costs associated with our growth strategy. We

                                       16
<PAGE>

expect to generate negative EBITDA for fiscal 2002. Costs associated with our
expenditures in marketing and sales, the continued development of our network
infrastructure and technology and expansions of our operations and workforce,
including our network operations, technical support, sales, marketing, product
research and development and administrative resources, will continue to
represent a large portion of our expenses during our anticipated expansion.

     EBITDA for fiscal 2001 and 2000 consists of losses from operations of
$48,235,000 and $13,558,000 plus depreciation and amortization of $15,516,000
and $2,214,000 plus amortization of unearned stock-based compensation of
$171,000 and $1,779,000, respectively. EBITDA does not represent funds available
for management's discretionary use and is not intended to represent cash flow
from operations as measured under generally accepted accounting principles.
EBITDA should not be considered as an alternative to net loss or net cash used
in operating activities, but may be useful to investors as an indication of
operating performance. This caption excludes components that are significant in
understanding and assessing the results of operations and cash flows. In
addition, EBITDA is not a term defined by generally accepted accounting
principles and, as a result, our calculations of EBITDA may not be consistent
with calculations of EBITDA used by others. However, we believe that EBITDA is
relevant and useful information that is often reported and widely used by
analysts, investors and other interested parties in the advanced hosting
industry. Accordingly, we are disclosing this information to permit a more
comprehensive analysis of our operating performance, as an additional meaningful
measure of performance and liquidity and to provide additional information with
respect to our ability to meet future working capital requirements.

Comparison of fiscal 2000 and 1999

Revenues

     Our revenues increased $9,944,000 to $11,833,000 for fiscal 2000 from
$1,889,000 for fiscal 1999.  Dedicated hosting revenue increased $5,840,000 to
$6,469,000, or 54.7% of revenue, for fiscal 2000 from $629,000, or 33.3% of
revenue, for fiscal 1999. Shared hosting revenue increased $1,343,000 to
$2,280,000, or 19.3% of revenue, for fiscal 2000 from $937,000, or 49.6% of
revenue, for fiscal 1999. Set-up fees increased $2,384,000 to $2,650,000, or
22.4% of revenue, for fiscal 2000 from $266,000, or 14.1% of revenue, for fiscal
1999. The increase was primarily due to the addition of new customers that
generated higher average monthly revenues.  Organic growth from some existing
customer accounts also contributed.

Cost of revenue

     Our cost of revenue increased $8,172,000 to $9,277,000, or 78.4% of
revenue, for fiscal 2000 from $1,105,000, or 58.5% of revenue, for fiscal 1999.
The increase in cost of revenue was due primarily to increases in personnel and
related costs, including employee recruiting fees, depreciation, bandwidth,
other hardware and software equipment costs, facilities, travel and professional
services. The increase as a percent of revenue was partially attributable to our
incurring these costs in advance of revenues. Personnel and related expenses
increased approximately $4,489,000 to $5,031,000, or 42.5% of revenue, for
fiscal 2000 from $542,000, or 28.7% of revenue, for fiscal 1999, as we increased
our systems and customer support personnel to 167 at March 31, 2000 from 19 at
March 31, 1999. Depreciation expense increased approximately $1,587,000 to
$1,676,000 for fiscal 2000 as we added approximately $23.2 million in computer
and related equipment since March 31, 1999. Our broadband services expenses
increased $994,000 to approximately $1,335,000 for fiscal 2000 from $342,000 for
fiscal 1999, to support our increased business activities. Other hardware and
software equipment costs increased $439,000 to $501,000 for fiscal 2000 to
support the growth in our business. Facilities expense increased $268,000 during
fiscal 2000 as a result of our move into a larger facility and the growth in
employees and as a result of the addition of a customer build center. Travel and
professional services increased $84,000 and $95,000, respectively, for fiscal
2000 reflecting the increased geographic dispersion of our customer base.

General and administrative

     General and administrative expense increased $6,514,000 to $7,575,000, or
64.0% of revenue, during fiscal 2000 from $1,061,000, or 56.2% of revenue,
during fiscal 1999.  The increase is primarily due to increases in personnel and
related expenses, including employee recruiting fees, travel professional
services, depreciation, amortization of warrant, facilities, supplies, insurance
and bad debt.  Personnel and related expenses increased

                                       17
<PAGE>

$4,012,000 to $4,640,000, or 39.2% of revenue, for fiscal 2000 from $628,000, or
33.3% of revenue, for fiscal 1999. We increased our number of employees in
general and administrative functions to 89 employees at March 31, 2000 from
eight employees at March 31, 1999. Travel expenses increased approximately
$400,000 to $444,000, or 3.8% of revenue, for fiscal 2000 from $44,000, or 2.4%
of revenue, for fiscal 1999. Professional services fees increased approximately
$414,000 to $499,000 for fiscal 2000 from $85,000 in the comparable period in
1999. Depreciation expense increased $344,000 in fiscal 2000, which is a result
of increased internal equipment necessary to support the growth of our business.
Amortization of product development costs related to the warrant we issued to
Microsoft in September 1999 increased $178,000. Facilities, supplies, and
insurance expense increased $338,000, $136,000 and $208,000, respectively, as a
result of our move into a larger facility and the growth in general and
administrative employees. Bad debt expense increased $493,000.

Marketing and sales

     Marketing and sales expense increased $5,549,000 to $6,212,000, or 52.5% of
revenue, during fiscal 2000 from $663,000, or 35.1% of revenue, during fiscal
1999.  The increase was due primarily to an increase in marketing and sales
personnel and related expenses, including employee recruiting fees and
advertising costs.  Personnel and related expenses increased $4,176,000 to
$4,547,000, or 38.4% of revenue, for fiscal 2000 from $370,000, or 19.6% of
revenue, for fiscal 1999.  Advertising costs increased $549,000 to $846,000 for
fiscal 2000 from $296,000 for fiscal 1999.  We increased our marketing and sales
personnel to 52 at March 31, 2000 from six at March 31, 1999.

Product research and development

     Product research and development expense increased $546,000 to $548,000 or
4.6% of revenue, during fiscal 2000 from $2,000 or .1% of revenue, during fiscal
1999.  The increase was due primarily to an increase in product research and
development personnel and related expenses, facilities costs, depreciation and
travel expenses.  Personnel and related expenses increased $479,000 to $481,000,
or 4.1% of revenue for fiscal 2000 from $2,000 or .1% of revenue, for fiscal
1999.  We increased our number of employees in product research and development
to 17 at March 31, 2000 from 1 at March 31, 1999.  Facilities costs,
depreciation and travel expenses increased $19,000, $2,000, and $40,000,
respectively, as a result of our move into a larger facility and the increase in
the number of product research and development employees.

Stock-based compensation

     Deferred stock compensation was recorded in connection with the grant of
employee stock options below fair value.  Amortization of stock-based
compensation totaled $1,779,000 for fiscal 2000 and $349,000 for fiscal 1999.
The amortization of stock-based compensation is based on the vesting schedule of
stock options held by the Company's employees. Stock based compensation in
fiscal 2000 includes the effect of options whose vesting was accelerated to the
date of our initial public offering, which closed in November 1999.

Other income (expense)

     Other income (expense) consists primarily of interest income on our cash
balances and interest expense on our outstanding notes payable and capital lease
obligations.  Interest earned on our cash and cash equivalents increased
$2,171,000 to $2,191,000 for fiscal 2000 from $20,000 for fiscal 1999.  This
increase was due primarily to the closing of our initial public offering in
October 1999, which resulted in larger cash balances available for investment.
During fiscal 2000, we increased interest expense $308,000 to $321,000 related
primarily to equipment capital leases entered into in the third and fourth
quarter of fiscal 2000.

Income taxes

     No provision for federal income taxes has been recorded as we have incurred
net operating losses since our inception.  We have recorded a valuation
allowance against all of our net deferred tax asset, which is primarily
attributable to net operating loss carry forwards, due to uncertainty that we
will generate sufficient taxable income during the carry forward period to
realize the benefit of our net deferred tax asset.

                                       18
<PAGE>

Net Loss

     Net loss increased $10,404,000 to $11,688,000 for fiscal 2000 from
$1,284,000 for fiscal 1999. As more fully discussed above, the increased net
loss is primarily attributable to increased costs as we continued to build our
business for anticipated growth.

EBITDA

     EBITDA decreased $8,723,000 to negative $9,565,000 for fiscal 2000 from
negative $813,000 for fiscal 1999. The decrease is primarily attributable to
costs associated with our growth strategy.  EBITDA consisted of losses from
operations of $13,558,0000 and $1,291,000 plus depreciation and amortization of
$2,214,000 and $129,000 plus amortization of unearned stock-based compensation
of $1,779,000 and $349,000 for fiscal 2000 and 1999, respectively.

Liquidity and Capital Resources

     We have historically financed our operations primarily through sales of
equity securities and capital leases. Since our inception, we have raised $15.9
million through private placements of our common stock. In November 1999, we
raised $85.9 million in net proceeds from our initial public offering. As of
March 31, 2001, we had cash and cash equivalents of $6.6 million and investments
in marketable securities of $26.8 million.

     Net cash used in our operating activities for the twelve-month period ended
March 31, 2001 was $29.1 million. The net cash used in operations was comprised
primarily of working capital requirements and our net loss, net of depreciation
and amortization. Net cash used in investing activities was $40.2 million for
the twelve-month period ended March 31, 2001 and consisted of the purchase of
marketable debt securities of  $37.9 million, redemptions of marketable debt
securities of $11.1 million and purchases of property and equipment of
approximately $13.4 million. Our purchases of property and equipment consisted
primarily of leasehold improvements, equipment to provide services to our
customers and purchases of furniture and equipment for new employees. We
acquired $23.7 million in computer and related equipment under capital leases
for the twelve-month period ended March 31, 2001.  Net cash used in financing
activities was approximately $9.5 million for the twelve-month period ended
March 31, 2001 and consisted primarily of principal payments on our notes
payable and capital leases.

     Total borrowings under our notes payable and capital lease obligations as
of March 31, 2001 were approximately $31.0 million.

     To help manage short-term liquidity needs without disrupting our investment
strategies, in December 1999 we entered into a revolving credit facility with
Bank One, Texas, N.A. This credit facility matures on July 31, 2001 and
outstanding balances accrue interest at the bank's base rate. We may borrow up
to $2.0 million under the credit facility but have not borrowed any amounts to
date. The facility is secured by all of our equipment that was unencumbered on
the date we entered into the facility and all accounts receivable outstanding
from time to time. Under certain limited circumstances, we could be required to
deposit cash with the bank to secure the loan. The credit facility contains
standard events of default and other covenants.

     Under our agreement with Level 3, we are required to purchase at least an
additional $8.3 million of bandwidth and colocation services over the next four
years.  Our quarterly commitment is $300,000 per quarter through July 2001,
$400,000 per quarter during the next 12 months, $600,000 per quarter during the
next 12 months and $1.0 million per quarter during the final 12 months of the
agreement.

     We believe that our current cash and investment balances should be
sufficient to meet our working capital and capital expenditure requirements
through March 31, 2002. We will continue to incur negative cash flows during
fiscal 2002 and thereafter. Therefore, we will be required to use our cash and
other liquid resources to support our operations. If we do not achieve the
results of operations that we expect as a result of lower than expected
revenues, higher than expected expenses or other possible adverse developments,
then we would be required either to secure additional sources of capital to
continue operating at our current level or to curtail our current operations.
Our operating activities on a long-term basis may require us to obtain
additional equity or debt financing. We finance under capital or operating
leases substantially all of the equipment we use to provide services to our
customers. As a

                                      19
<PAGE>

result, our investments in this type of equipment will require us to obtain
additional lease or other financing in the future. In addition, although we have
no present understandings, commitments or agreements with respect to any
acquisition of other businesses, products, services or technologies, we may
evaluate potential acquisitions of other businesses, products and technologies
from time to time. In order to consummate potential acquisitions, we may need
additional equity or debt financings in the future. If we require additional
financing for any reason, there can be no assurance that such additional
financing will be available to us on acceptable terms, or at all. In the event
we are unable to raise additional capital, we may be required to substantially
reduce or curtail operations. Further, if additional funds are raised through
the issuance of additional equity securities, the percentage ownership of our
shareholders would be diluted. Any new equity securities may have rights,
preferences or privileges senior to those of our common stock.

Recent Accounting Pronouncements

     In December 1999, the Securities and Exchange Commission issued SAB 101
which summarizes some of the SEC staff's views in applying generally accepted
accounting principles to revenue recognition in financial statements. We adopted
the new guidance as a change in accounting principle in January 2001 but
effective April 1, 2000. We changed our method of recognizing revenue on set up
fees to defer the revenue and recognize it over the initial term of the
contracts with our customers. The change in accounting method has been accounted
for as a cumulative effect adjustment, which resulted in (a) the financial
information for the quarters of fiscal 2001 prior to adoption of SAB 101 being
restated and (b) the cumulative effect adjustment being reflected in the first
quarter of the year of adoption of SAB 101. As a result of the cumulative effect
adjustment on prior years, which totals approximately $1,626,000, revenue that
has previously been recognized in our financial statements has been and will
continue to be amortized to income in financial reporting periods subsequent to
the period of adoption of SAB 101.

Risk Factors

     The risks and uncertainties described below are not the only risks we face.
Additional risks and uncertainties not presently known to us or that are
currently deemed immaterial may also impair our business operations. If any of
the following risks actually occur, our financial condition and operating
results could be materially adversely affected.

We have a history of substantial losses, and we anticipate continuing losses.

     We have experienced operating losses and negative cash flows from
operations in each quarterly and annual period since incorporating in 1997. We
experienced net losses of approximately $48.8 million, or negative 97.4% of
revenues, for fiscal 2001. As of March 31, 2001, we had an accumulated deficit
of approximately $61.7 million. We expect our operating expenses to increase
significantly as we attempt to expand our business. We are required to purchase
$300,000 of colocation and bandwidth services from Level 3 during the first
quarter of fiscal 2002 and an additional $1.2 million during fiscal 2002. We
anticipate increased expenses as we continue to expand and improve our
infrastructure, introduce new services, develop our distribution channel, fund
research and development, support and improve our operational and financial
systems, broaden customer service and support, enhance our hosting and managed
services capabilities, expand our sales and marketing efforts, expand
internationally and pursue additional industry relationships. As a result, we
expect to incur operating losses for at least the next fiscal year. We cannot
assure you that we will ever be profitable on a quarterly or annual basis or
that, if we achieve profitability, it will be sustainable.

We may need additional capital to fund our operations, and we may not be able to
obtain it on terms acceptable to us or at all.

     We believe that our existing capital resources, including the remaining
proceeds from our initial public offering in October 1999 and the amounts
available under our capital lease facilities, will enable us to maintain our
current operations through March 31, 2002.  However, we may require additional
funds during or after that period. In particular, we would be required to secure
additional sources of capital to continue operating at our current level or
curtail our current operations if we do not achieve the results of operations
that we expect as a result of lower than expected revenues, higher than expected
expenses or other possible adverse developments.  In addition, if we

                                       20
<PAGE>

expand our existing business plan to focus on growth in international markets,
make acquisitions of businesses or technologies or modify our business plan in
other ways, we would likely require additional funding. If we require additional
financing for any reason, there can be no assurance that such additional
financing will be available to us on acceptable terms, or at all. In the event
we are unable to raise additional capital, we may be required to substantially
reduce or curtail operations. Further, if additional funds are raised through
the issuance of additional equity securities, the percentage ownership of our
shareholders would be diluted. Any new equity securities may have rights,
preferences or privileges senior to those of our common stock.

Our business and prospects are difficult to evaluate because we have a limited
operating history and our business model is still evolving.

     It is difficult to evaluate our business operations and our prospects
because of our limited operating history and the pace of change in our business.
We were incorporated in August 1997 and commenced operations in September of
that year with a focus on hosting services, and our business model is still new
and evolving. The revenue and income potential of our business is unproven. Our
limited operating history and the relative newness of the industry in which we
operate makes predicting future results difficult. We may not be able to
successfully implement our business plan or adapt it to changes in the market.
If we are not able to do so, our business, results of operations and financial
condition will be adversely affected.

Our quarterly and annual results may fluctuate, resulting in fluctuations in the
price of our common stock.

     Our operating results may fluctuate significantly in the future on a
quarterly and annual basis. Because of these fluctuations, comparisons of our
operating results from period to period are not necessarily meaningful and
should not be relied upon as an indicator of future performance. We expect to
experience significant fluctuations as a result of a variety of factors, many of
which are outside of our control. The following factors could affect our
operating results:

     . demand for our services;

     . size and timing of customer installations and related payments;

     . reliable services and network availability;

     . ability and costs associated with increasing network and data center
       capacity;

     . fluctuations in data and voice communications costs;

     . fluctuations in hardware and software costs;

     . timing and magnitude of capital expenditures and other expenses;

     . costs relating to operations;

     . customer retention and satisfaction;

     . introduction by third parties, including our competitors, of new products
       and services;

     . termination or reduction of services by customers, including terminations
       by customers that do not have sufficient funding to continue their
       operations, either at all or at the level contemplated by our agreements
       with them;

     . customer discounts and credits;

     . timing and success of marketing efforts and service introductions by us;

     . changes in our pricing policies or those of our competitors;

                                       21
<PAGE>

     . retention of our key personnel; and

     . economic conditions specific to the hosting industry, as well as general
       economic conditions.

We expect that our operating expenses will continue to increase as we further
develop our business. If our revenues do not increase as quickly as our
expenses, our operating results will suffer.

     A portion of our operating costs are fixed at certain minimum levels,
including our expenses for data center capacity, depreciation, interest,
hardware lease payments, minimum bandwidth charges, real estate lease payments
and personnel. Therefore, our results of operations are particularly sensitive
to fluctuations in revenue. If our revenues do not increase as expected, we will
still have to pay these fixed costs and our results of operations and financial
condition would be adversely affected. Furthermore, many of our customers are
relatively new business, or Internet-focused business initiatives of more
established companies, and these businesses or initiatives may have negative
cash flows or may not be successful, or both. As a result, we may not be able to
collect revenues for the services we provide on a timely basis or at all.

     For these and other reasons, in future periods our operating results may
fall below the expectations of securities analysts or investors, which could
result in widely varying stock prices and negatively affect the market price of
our common stock.

Our customer base includes a significant number of businesses that currently
face increasing difficulty in obtaining funding to support their operations.

     Many of our customers are businesses, including Internet-based businesses,
that have traditionally been initially funded by venture capital firms and then
through public securities offerings. Funding alternatives for these businesses
have become more limited than in the past. The unproven business models of many
of our customers and the uncertain economic climate make their continued
viability uncertain. Many of these customers have ceased or reduced their
operations, and it is has become increasingly difficult for us to collect our
accounts receivable from these businesses. If the market for technology and
Internet-based businesses is not supported by the private and public investors
who have funded these customers or if their business models prove to be
unsuccessful, we face the risk that these customers may cease, curtail or limit
web site operations hosted by us. If this continues to occur, we would likely
experience a loss of revenue associated with these customers and will then have
to increase sales to other businesses in order to preserve and grow our revenue.
If we are successful in increasing sales to other businesses, we will incur the
expenses associated with these new customers, such as sales and marketing
expenses, including commissions, and implementation costs. As a result, to
preserve and grow our revenue, we will have to increase sales by substantially
more than the amount of lost revenue.

Because we operate in a new and evolving market with uncertain prospects for
growth, we may be unable to sustain growth in our customer base and our
operating results may suffer.

     Our market is new and rapidly evolving. Growth in demand for and acceptance
of advanced hosting services is highly uncertain. Businesses may not be aware of
the potential benefits of outsourcing or may find it less expensive, more secure
or otherwise preferable to host their web sites internally. Internet
technologies, such as e-commerce applications, which require advanced hosting,
may not grow as rapidly as we expect. We currently incur costs that are greater
than our revenues. If we cannot grow and retain our customer base, we will not
be able to offset our fixed and operating costs. Our future growth, if any, will
depend on businesses outsourcing the management of their Internet and other
applications and our ability to sell our services to these businesses in a cost-
effective manner to a sufficient number of these businesses. If the market for
advanced hosting services fails to grow or grows more slowly than anticipated or
if we are unable to respond effectively to changes in this market, our business,
operating results and financial condition will be adversely affected. Growth in
the demand for our products and services may be inhibited, and we may be unable
to sustain growth in our customer base for a number of reasons, including:

     . our inability to market our products and services in a cost-effective
       manner to new customers;

     . the inability of customers to differentiate the products and services we
       offer from those of our competitors;

                                       22
<PAGE>

     . our inability to strengthen awareness of our brand; and

     . reliability, quality or compatibility problems with our services.

We rely on our strategic relationship with Level 3, and if this relationship is
terminated or deteriorates our business may suffer.

     In July 1999, we entered into a strategic relationship with Level 3. Level
3 is a communications and information services company that is building an
advanced facilities-based communications network through which it provides
colocation, Internet connectivity and other services. As part of our
relationship, we have committed to purchase a fixed amount of services from
Level 3, including, among other things, bandwidth, colocation space, and
installation and maintenance services, over the next three years. We will incur
these expenses even if anticipated increases in sales do not materialize or, in
some circumstances, if the agreement is terminated. We have also agreed that if
Level 3 is capable of providing the services we request, and if those services
are substantially similar to other services that we purchase, we will purchase
90% of these services from Level 3 through June 2004. We are required to
purchase these services from Level 3 even if these services are available at
lower prices from alternative vendors. We route the network traffic of our
customers through multiple backbone providers to increase network performance.
To enable us to do this, we obtain Internet connectivity through a number of
providers, and Level 3 may not be able to provide all of the connectivity
services that we require. As a result, we may purchase less than the applicable
percentages of these services from Level 3.

     We also currently rely on Level 3 to provide substantially all of the data
center capacity that we need to provide our hosting services, and in the future
we may be required to purchase most of our data center capacity from Level 3.
Further, Level 3 may provide personnel at these data centers to install
equipment and assist with support as necessary for us to deliver service in
these facilities. If Level 3 fails to provide this data center capacity or
perform these services in a timely or effective manner, or at all, we would be
required to make alternate arrangements. If demand for colocation space
increases, Level 3 may not be able or willing to provide the data center
capacity we require to deliver our services. If our relationship with Level 3 is
terminated or if Level 3 does not provide the data center capacity that we need,
or provide it on acceptable terms, we would be required to seek arrangements
with other data center providers or construct our own data centers. We cannot be
certain that alternate data center capacity will be available on commercially
reasonable terms or at all. We currently rely, and for the foreseeable future
will continue to rely, on Level 3 to provide a substantial part of our bandwidth
and other networking services. If we were not able to obtain these services from
Level 3, we would be required to seek arrangements with other providers of these
services, and we cannot be certain that alternate services will be available on
commercially reasonable terms or at all.

Our success depends on Microsoft's continued success, and the loss or
deterioration of our relationship with Microsoft could harm our business and
have an adverse impact on our revenues.

     We focus on advanced hosting services for Microsoft-based Internet
technologies. If these technologies are not widely used building blocks for
advanced Internet sites in the future, the demand for our services would
decrease and our business would be adversely affected. The final outcome of the
antitrust case against Microsoft is uncertain, but the outcome could cause the
acceptance of Microsoft products to decrease. Except for our relationship with
Microsoft as a customer, and under the Development, License, and Co-Marketing
Agreement, our relationship with Microsoft is generally informal. We believe
this relationship provides us with access to developments in Microsoft products
before they are generally available, which allows us to maintain and enhance our
technical expertise. If our relationship with Microsoft deteriorates or if we
lose some of the status or privileges we currently enjoy, our technical
expertise could be adversely affected. Our ability to market our services as a
provider of advanced hosting services for Microsoft-based Internet technologies
would also be adversely affected if Microsoft does not continue to confer
certifications and designations on us, or changes our current certifications and
designations. We do not have a written agreement with Microsoft relating to all
of these certifications or designations. Some of our competitors also have
received these certifications and designations. Microsoft generally confers
these certifications unilaterally and in its sole discretion and could change
them at any time. We cannot be certain that we will continue to enjoy them.

                                       23
<PAGE>

We operate in an extremely competitive market, and our business would suffer if
we are unable to compete effectively.

     The market for hosting and Internet services is highly competitive. There
are few substantial barriers to entry to keep new competitors from entering this
market. We expect that we will face additional competition from existing
competitors and new market entrants in the future. Recently, many companies,
including many large, established companies, have announced that they will begin
to provide or plan to greatly expand their service offerings that are
competitive with ours. These companies and many of our other competitors have
substantially greater financial, technical and marketing resources, larger
customer bases, longer operating histories, greater name recognition and more
established relationships in the industry than we do. As a result, some of these
competitors may be able to:

     .  develop and expand their network infrastructures and service offerings
        more rapidly;

     .  adapt to new or emerging technologies and changes in customer
        requirements more quickly;

     .  take advantage of acquisition and other opportunities more readily;

     .  devote greater resources to the marketing and sales of their services;
        and

     .  adopt more aggressive pricing policies.

     In addition, some of our competitors have entered and will likely continue
to enter into joint ventures or other arrangements to provide additional
services competitive with those provided by us. The market in which we compete
is has experienced consolidation, and we believe that it is likely to continue
to experience consolidation in the future, which could result in increased
competition on price and other factors that could adversely affect our business.

     Some of our competitors may be able to provide their customers with
additional benefits in connection with their Internet system and network
management solutions, including reduced communications costs, which could reduce
the overall costs of their services relative to ours. We may not be able to
offset the effects of any price reductions. In addition, we believe our market
is likely to consolidate in the near future, which could result in increased
competition, including price competition.

     In an effort to gain market share, some of our competitors have offered
incentives not matched by us. In addition, some of our competitors may be able
to provide customers with additional benefits that could reduce the overall
costs of their services relative to ours. We may not be able to reduce the
pricing of our services or offer incentives in response to the actions of our
competitors without an adverse impact on our business.

If we are unable to expand our network infrastructure to meet increasing demand
for reliable and secure services, we could lose customers and our operating
results could suffer.

     We must continue to expand and adapt our network infrastructure to
accommodate an increasing number of customers, the amount of information they
wish to transmit and their changing requirements. We face risks related to our
network's ability to be scaled to meet increasing customer levels while
maintaining acceptable performance levels. The continued expansion and
adaptation of our networking and hosting infrastructure will continue to require
substantial financial, operational and management resources as we negotiate
bandwidth capacity with existing and other network infrastructure suppliers. If
we are required to expand our network significantly and rapidly due to increased
usage, additional stress will be placed upon our network hardware, traffic
management systems and hosting facilities as well as our financial, operational
and management resources. The ability of our network to support a substantially
larger number of customers at high transmission speeds is unknown. Furthermore,
it may be difficult for us to increase quickly our network capacity in light of
current lead times to purchase circuits and other critical items. If the network
providers upon which we rely fail to provide reliability, capacity and
performance for our network, we could lose customers and our operating results
could suffer.

                                       24
<PAGE>

If the networks through which we deliver services do not have sufficient
capacity, reliability or security, we could lose customers and our business
would suffer.

     Our success partly depends upon the capacity, reliability and security of
our network infrastructure, including the capacity leased from our network
suppliers. Our network currently delivers service through Level 3, InterNap,
AT&T, GTE, Netcom/Mindspring, PSINet, Qwest, Verio, MCI WorldCom, Inc.,
including UUNET Technologies, Inc., Sprint Corporation, Digex Incorporated,
Cable & Wireless plc and SAVVIS Communications Enterprises, LLC. Some of these
suppliers are also our competitors. In the future, we will be required to
purchase most of our network capacity from Level 3 to the extent that it
provides capacity that is substantially similar to the capacity of other
providers. We depend on these companies to provide uninterrupted and error-free
service through their telecommunications networks. If our customers' usage of
telecommunications capacity increases, we will need to make additional
investments in our infrastructure to maintain adequate data transmission speeds,
the availability of which may be limited or the cost of which may be
significant. We monitor all network links to prevent their being utilized in
excess of their recommended capacity. If our customers' usage increases and
capacity is not available to us, our network may not be able to achieve or
maintain sufficiently high data transmission capacity, reliability or
performance. In addition, our business would suffer if our network suppliers
increased the prices for their services and we were unable to pass along any
increased costs to our customers. Any failure on our part or the part of our
third-party suppliers to achieve or maintain high data transmission capacity,
reliability or performance could significantly reduce customer demand for our
services and damage our business.

Increased costs associated with our private transit Internet connections could
result in the loss of customers or significant increases in operating costs.

     Our private transit Internet connections are more costly than other
arrangements commonly utilized to move Internet traffic. If providers increase
the pricing associated with utilizing their bandwidth, we may be required to
identify alternative methods to distribute our customers' digital content. We
cannot assure you that our customers will continue to be willing to pay the
higher costs associated with direct private transit or that we could effectively
move to another network approach. If we are unable to access alternative
networks to distribute our customers' digital content on a cost-effective basis
or to pass any additional costs on to our customers, our operating costs would
increase significantly.

We may not be able to deliver our services and our business may suffer if our
third-party suppliers do not provide us with key components of our network
infrastructure.

     We depend on other companies to supply key components of our network
infrastructure. Any failure to obtain needed products or services in a timely
fashion or at an acceptable cost could adversely affect our business. We buy
servers, routers and switches on an as-needed basis and therefore do not carry
significant inventories of them. We also have no guaranteed supply arrangements
with our vendors. We currently only use servers from Compaq and rely on Compaq
to provide us with access to Compaq technical personnel. In July 1999, we
entered into an agreement with Compaq under which we agreed during the
immediately following three years to purchase from Compaq the lesser of 2,000
servers or the number of servers reasonably necessary to adequately operate our
business consistent with our business plan. Through March 31, 2001, we had
purchased approximately 1,800 servers from Compaq under this agreement. Our
requirement to purchase these servers is contingent upon Compaq providing
financing for the servers on competitive terms, upon the price, performance and
quality of the Compaq servers being reasonably satisfactory to us and upon
Compaq's commitment to deliver these servers on the schedule we request. In
addition, we rely on Cisco Systems, Inc. and others to supply equipment critical
to our network, but we do not have a supply agreement with any of them. If this
equipment were to become unavailable on terms acceptable to us, we would be
forced to find alternative equipment. The inability to obtain equipment or
technical services from Compaq, Cisco or others on terms acceptable to us would
force us to spend time and money selecting and obtaining new equipment, training
our personnel to use different equipment and deploying alternative components
needed to integrate the new equipment, and as a result our business could be
adversely affected. In addition, if our sole or limited source suppliers do not
provide products or components that comply with evolving Internet and
telecommunications standards or that interoperate with other products or
components we use, our business would be harmed. For example, we have
experienced performance problems, including previously unknown software and
firmware bugs, with routers and switches that have caused disruptions in and
impairment of network performance.

                                       25
<PAGE>

We may not be able to adapt to evolving technologies and customer demands, which
could cause our business to suffer.

  Our future success will depend on our ability to offer services that
incorporate leading technology and address the increasingly sophisticated needs
of our current and prospective customers. Our market is characterized by rapidly
changing and unproven technology, evolving industry standards, changes in
customer needs and frequent new product announcements. These characteristics are
magnified by the growth of the Internet and the intense competition in our
industry. We are also subject to risks from technological changes in the way
hosting solutions are marketed and delivered. Future advances in technology may
not be beneficial to or compatible with our business. To be successful, we must
adapt to our rapidly changing market by continually improving the performance,
features and reliability of our services and modifying our business strategies
accordingly. We could also incur substantial costs if we need to modify our
services or infrastructure in order to adapt to these changes. In addition, our
internal costs to provide service to our customers could be adversely affected.
Our business would suffer if we fail to respond to these changes in a timely and
cost-effective manner or at all. Our business will suffer if Internet usage does
not continue to increase or if the Internet fails to perform reliably.

     Our ability to successfully market our services could be substantially
impaired if we are unable to deploy new Internet technologies or service
offerings or if new Internet technologies or service offerings deployed by us
prove to be unreliable, defective or incompatible.

     We cannot assure you that we will not experience difficulties that could
delay or prevent the successful development, introduction or marketing of
Internet technologies in the future. If any newly introduced Internet
technologies or our service offerings 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 adversely affected.
In addition, technological advances may have the effect of encouraging our
customers or prospective customers to rely on in-house personnel and equipment
to provide the services we provide. We cannot assure you that new applications
or services 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 offer and deploy new Internet technologies or enhancements
of existing technologies, our ability to successfully market our services could
be substantially impaired.

     We believe that our ability to successfully compete is also dependent upon
the continued compatibility of our services with products, services and
architectures offered by various other companies. While we work with many
vendors to test newly developed products, these products may not be compatible
with our infrastructure or adequate to address changing customer needs. Any
incompatibility could require us to make significant investments to achieve
compatibility. If industry standards emerge, we may not be able to comply with
them. Our failure to conform with any industry standards, or the failure of a
common standard to emerge, could adversely affect our business.

Our business will not grow unless Internet usage grows and Internet performance
remains adequate.

     Use of the Internet for retrieving, sharing and transferring information
among businesses, consumers, suppliers and partners has increased rapidly. Our
success depends in large part on continued growth in the use of the Internet. In
addition, our business plan anticipates significant growth in the web site
hosting and application hosting markets. The growth of the Internet, including
the web site hosting and application hosting markets, is subject to a high level
of uncertainty and Internet usage and growth may be inhibited for a number of
reasons, such as:

     . inadequate network infrastructure;

     . security concerns, including viruses and denial of service attacks;

     . uncertainty of legal and regulatory issues concerning the use of the
       Internet;

     . inconsistent quality of service;

                                       26
<PAGE>

     .  the inability of Internet-based businesses to develop and maintain
        successful business models;

     .  failure of Internet-based businesses;

     .  lack of availability of cost-effective, reliable, high-speed service;
        and

     .  failure of Internet use to expand internationally.

     If Internet usage grows, the Internet infrastructure may not be able to
support the demands placed on it by this growth, or its performance and
reliability may decline. For example, web sites have experienced interruptions
in service as a result of outages and other delays occurring throughout the
Internet network infrastructure. If these outages or delays occur frequently,
use of the Internet as a commercial or business medium could in the future grow
more slowly or decline, which would adversely affect our business.

     Any degradation in the performance of the web sites and other applications
we host could undermine the benefits customers perceive in our services.
Ultimately, the performance of the web sites and other applications we host
relies upon the speed and reliability of networks operated by third parties. As
a result, the growth of the market for our services and our ability to grow
depends on the continued improvement of the entire Internet infrastructure. Many
of the companies that have historically built new network capacity do not have
access to the capital resources they did in the past. Consequently, they may not
continue to invest in new network capacity at the same rates as they have in the
past, or at all, which could adversely affect our business, operating results
and financial condition.

Failure of our operating and financial systems to keep pace with the anticipated
growth in our business could result in customer dissatisfaction, operating
inefficiencies and lost revenue opportunities.

     The rapid growth of our business and our service offerings has placed, and
is likely to continue to place, a significant strain on our operating and
financial resources. Our future performance will partly depend on our ability to
manage our growth effectively, which will require that we further develop our
operating and financial system capabilities and controls. If our information
systems and other infrastructure, including customer service and support, are
unable to support the demands placed on them by the rapid growth in our
business, we may be forced to implement new systems. If we fail to improve our
operational systems or to expand our customer service capabilities to keep pace
with the growth of our business, we could experience customer dissatisfaction,
cost inefficiencies and lost revenue opportunities, which could harm our
operating results. We may not be able to successfully implement these systems
when needed or they may not perform reliably.

     We are currently developing internally a software application on which we
intend to run our business. We expect that this application will provide the
framework in which we provide services to our customers, including provisioning
and service and support. We have expended, and will continue to expend
significant resources in developing this application. If we are unable to
develop this system in a cost-effective and timely manner, or at all, or if the
functionality we develop in this system does not support our business, our
business, financial condition and operating results could be adversely affected.

We may not be able to successfully sustain our growth if we are unable to retain
and attract highly skilled personnel.

     Our business requires individuals with significant levels of specific
technical expertise. Competition for such personnel is intense, making it
increasingly difficult to retain and attract the highly skilled employees
necessary to provide the level of services that our customers expect. In light
of the recent reduction in our work force and the decline in our stock price
over the last 12 months, it may be difficult for us to retain and attract
qualified personnel. We expect that we will gradually expand our sales and
marketing staff to generate increased revenues. We may not be able to attract
qualified personnel to fill new positions or to replace any of our current
employees that we lose. We may be forced to provide higher compensation to such
personnel than we currently anticipate, and the costs associated with training
and integrating such new employees could be significant. If we are unable to
effectively retain and attract qualified personnel on a cost-efficient basis,
our operations and financial results could be adversely affected.

                                       27
<PAGE>

We could experience system failures that could harm our business and reputation.

     To succeed, we must be able to operate our network management
infrastructure without interruption. Our operations depend upon our ability to
protect our network infrastructure, equipment and customer files against damage
from human error, fire, earthquakes, hurricanes, floods, power loss,
telecommunications failures, intrusion (including hackers), sabotage,
intentional acts of vandalism and similar events. Our servers and network
infrastructure are located primarily in the Dallas/Ft. Worth, Texas metropolitan
area. The occurrence of a natural disaster or other unanticipated problems at
any of the data centers from which we provide services could result in
interruptions in the services we provide to our customers.

     Although we have attempted to build redundancy into our network and hosting
infrastructure, we have experienced interruptions in service in the past. We
have experienced partial system failures due to routing problems, hard drive
failures, database corruption and other computer failures. Our network is
subject to various points of failure, and a problem with our routers, switches
or other equipment could cause an interruption in the services we provide to
some or all of our customers. Any future interruptions could:

     .  cause customers or end users to seek damages or service credits for
        losses incurred;

     .  require us to replace existing equipment or add redundant facilities;

     .  damage our reputation for reliable service;

     .  cause existing customers to cancel their contracts; or

     .  make it more difficult for us to attract new customers.

Any of these results could damage our business.

Our customer's satisfaction with our services is critical to our business.

     Our customers demand a high level of service. As customers outsource the
hosting and management of business-critical applications to us, we are subject
to liability claims and customer dissatisfaction if our systems fail or if we
fail to maintain the availability of these applications. Our customer contracts
generally provide some service level commitment that provides for remedies if
their applications do not maintain a specified level of availability. If we
incur significant service level commitment obligations in connection with
downtime or system failures, we could be required to issue significant credits
or pay significant damages, or both. Our liability insurance might not be
adequate to cover such credits or damages. Any significant interruptions of
service could result in claims and adversely affect our business, financial
condition and results of operations.

Disruption of our services caused by unknown software defects could harm our
business and reputation.

     Our service offerings depend on complex software, including software
licensed from third parties and our proprietary software tools. Complex software
often contains defects, particularly when first introduced or when new versions
are released. We may not discover software defects that affect our new or
current services or enhancements until after they are deployed. These defects
could cause service interruptions or performance issues, which could damage our
reputation or increase our service costs, cause us to lose revenue, delay market
acceptance or divert our development resources.

Our business and reputation will suffer if we do not prevent security breaches.

     Unauthorized access, computer viruses, denial of service attacks,
accidents, misconduct resulting in disruptions and other disruptions could
occur. In addition, we may incur significant costs to prevent breaches in
security or to alleviate problems caused by breaches. We work with Level 3 and
other colocation vendors to protect our equipment and hardware against breaches
in physical security and with other vendors of software and hardware to protect
other breaches in security. We cannot be certain that they will provide adequate
security. We have experienced and may in the future experience delays or
interruptions in service as a result of the accidental or intentional actions of
Internet

                                       28
<PAGE>

users, current and former employees of Data Return or others. Furthermore,
inappropriate use of the network by third parties could also jeopardize the
security of confidential information, such as customer and Data Return passwords
as well as credit card and bank account numbers, stored in our computer systems
or those of our customers. As a result, we could become liable to others and
lose existing or potential customers. The costs required to eliminate computer
viruses and alleviate other security problems could be prohibitively expensive.
In addition, the efforts to address these problems could result in
interruptions, delays or cessation of service to our customers.

Providing services to customers with mission-critical web sites and web-based
applications could potentially expose us to lawsuits for customers' lost profits
or other damages.

     Because our hosting services are critical to many of our customers'
businesses, any significant interruption in our services could result in lost
profits or other indirect or consequential damages to our customers. Although
many of our contracts disclaim our liability for any such damages, a customer
could still bring a lawsuit against us claiming lost profits or other
consequential damages as the result of a service interruption or other web site
or application problems that the customer may ascribe to us. There can be no
assurance a court would enforce any limitations on our liability, and the
outcome of any lawsuit would depend on the specific facts of the case and legal
and policy considerations. There can be no assurance we would prevail. In such
cases, we could be liable for substantial damage awards. Such damage awards
might exceed our liability insurance, which could seriously harm our business.

Our limited ability or failure to protect our intellectual property may
adversely affect our ability to compete.

     Third parties may infringe or misappropriate our technology or proprietary
rights, which could have an adverse effect on our business, results of
operations or financial condition. In addition, our competitors or potential
competitors may independently develop technologies that are equivalent or
superior to our technology. We rely on a combination of copyright, trademark,
service mark and trade secret laws to protect our intellectual property. We have
filed federal registrations for the mark "Data Return" and other marks. We also
have internally developed software and other tools that are important to our
business for which we rely on copyright protection. We have entered into
contractual arrangements with some of our employees and contractors as well as
suppliers, distributors and some of our customers in order to limit access to,
and any disclosure of, our proprietary information. The steps we have taken to
protect our intellectual property may be insufficient. We may need to take legal
action to protect our intellectual property rights, which could be costly and
divert the attention of our technical and management personnel.

We may be accused of infringing the proprietary rights of others, which could
subject us to costly and time-consuming litigation.

     In addition to the technologies we develop or have developed, we license
certain technologies from third parties and may license additional technologies
in the future. We could become subject to infringement actions based upon our
internally developed technologies or technologies licensed from third parties.
Any of these claims, with or without merit, could subject us to costly
litigation and divert the attention of our technical and management personnel.
In addition, third parties may change the terms of their license agreements in
ways that would prevent us from using technologies licensed from them on
commercially reasonable terms or that would prevent us from using them at all.
We may not be able to replace those technologies with technologies that have the
same features or functionality on commercially reasonable terms or at all.

Regulatory and legal uncertainties could result in significant costs or
otherwise harm our business.

     The success of our business depends on the growth of the Internet. Laws and
regulations directly applicable to commerce or communications over the Internet
are becoming increasingly prevalent. However, the law of the Internet remains
largely unsettled. The adoption or modification of laws or regulations relating
to the Internet could adversely affect our business if they impose a direct cost
on us or if they curtail the growth of the Internet. If liability for materials
carried on or disseminated through their systems is imposed on service
providers, we would make efforts to implement measures to reduce our exposure to
such liability. Such measures could require us to expend substantial resources
or discontinue certain product or service offerings. In addition, increased
attention to liability issues, as a result of lawsuits, legislation and
legislative proposals, could divert management attention, result in

                                       29
<PAGE>

unanticipated expenses and harm our business. If legislation is adopted in the
U.S. or internationally that makes transacting business over the Internet, such
as e-commerce, less favorable or otherwise curtails the growth of the Internet,
our business would suffer.

We may be subject to legal claims in connection with the information
disseminated through our network which could have the effect of diverting
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, violation
of securities laws 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 which could have the
effect of diverting management's attention and require us to expend significant
financial resources. Our liability insurance may not cover any of these claims
or may not be adequate to protect us against all liability that may be imposed
or claimed.

     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 massive numbers of people, typically to
advertise products or services. This practice, known as "spamming," can lead to
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.

The loss of key personnel including our Chairman and Chief Executive Officer,
our President and our Chief Operating Officer could harm our business.

     We depend on the continued service of our key technical, sales and senior
management personnel, including Sunny C. Vanderbeck, our Chairman and Chief
Executive Officer, Michelle R. Chambers, our President, and Robert A. Prosen,
our Chief Operating Officer. We have entered into employment agreements with Mr.
Vanderbeck, Ms. Chambers and Mr. Prosen expiring in June 2002, but any of our
officers or employees can quit at any time. Losing one or more of our key
employees could harm our business.

Difficulties presented by international economic, political, legal, accounting
and business factors could harm our business in international markets.

     A component of our strategy is to expand into international markets. The
rate of development and adoption of the Internet has been slower outside of the
United States, and the cost of bandwidth has been higher, which may adversely
affect our ability to expand operations and may increase our cost of operations
internationally. The risks inherent in conducting business internationally
include:

     . unexpected changes in regulatory requirements, export restrictions,
       tariffs and other trade barriers;

     . challenges in staffing and managing foreign operations;

     . differences in technology standards;

     . less protective intellectual property laws;

     . employment laws and practices in foreign countries;

     . longer payment cycles and problems in collecting accounts receivable;

     . political instability;

     . fluctuations in currency exchange rates and imposition of currency
       exchange controls; and

                                       30
<PAGE>

     . potentially adverse tax consequences.

Our management will have significant flexibility in applying the proceeds from
our initial public offering and our use of proceeds may not yield a favorable
return.

     We have used and intend generally to continue to use the net proceeds from
our November 1999 initial public offering to fund our capital expenditures and
for working capital and other general corporate purposes. We may also acquire or
make investments in other businesses, products, services or technologies and, if
we do, we may not be able to make those acquisitions or investments on
commercially acceptable terms or we could have difficulty assimilating and
integrating any acquired businesses, technologies, services or products. We have
not yet determined all expected expenditures and thus cannot estimate the
amounts to be used for each specified purpose. Our management has significant
flexibility in applying the net proceeds of our initial public offering. We
cannot be certain that our use of the proceeds will yield a favorable return.

Our principal shareholders, directors and executive officers currently own
approximately 63.5% of our common stock, which may allow them to exert influence
over us or to prevent a change of control.

     Our directors and executive officers and shareholders who currently own
over 5% of our common stock collectively beneficially own approximately 63.5% of
our outstanding common stock. These shareholders would be able to exercise
significant influence over all matters requiring shareholder approval, including
the election of directors and approval of significant corporate transactions.
This concentration of ownership could also delay or prevent a change in control
of Data Return even if beneficial to our shareholders.

Some provisions of our articles, bylaws and rights plan and of Texas law could
delay or prevent a change of control, which could adversely affect our stock
price.

     Our articles of incorporation and bylaws contain provisions that could make
it more difficult for a third party to acquire us, even if doing so would be
beneficial to our shareholders. These provisions could limit the price that
investors might be willing to pay in the future for shares of our common stock.
Some of these provisions:

     . authorize the issuance of preferred stock which can be created and issued
        by our board of directors without prior shareholder approval, commonly
        referred to as "blank check" preferred stock, with rights senior to
        those of common stock;

     . prohibit certain shareholder actions by written consent;

     . establish advance notice requirements for submitting nominations for
        election to our board of directors and for proposing matters that can be
        acted upon by shareholders at a meeting; and

     . provide for a board of directors with staggered three-year terms.

We have also adopted a shareholders' rights plan that could delay, deter or
prevent a change in control of us.

     In September 1999, we adopted a shareholder rights plan. This plan entitles
our shareholders to rights to acquire additional shares of our common stock when
a third party acquires 15% of our common stock or commences or announces its
intent to commence a tender offer for at least 15% of our common stock. This
plan could delay, deter or prevent a change in control of us.

Future sales of our common stock could cause our stock price to decline.

     At March 31, 2001, 35,978,944 shares of our common stock were issued and
outstanding. We cannot be sure what effect, if any, future sales of our common
stock or the availability of shares for future sale will have on the market
price of our common stock. The market price of our common stock could drop due
to sales of a large number of shares of our common stock in the market or the
perception that these sales could occur. These factors could also make it more
difficult to raise funds through future offerings of our common stock.

                                       31
<PAGE>

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     All our customer contracts are currently denominated in United States
dollars, and we do not currently invest in derivative financial instruments.
However, we invest our excess cash balances in cash equivalents and are
therefore subject to market risk related to changes in interest rates. We
believe, but cannot be certain, that the effect on our financial position,
results of operations and cash flows of any reasonably likely changes in
interest rates would not be material.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Financial Statement and Financial Statement Schedule
----------------------------------------------------

     The following financial statements of the Company and the notes thereto and
the related report thereon of the independent auditors, and financial statement
schedule, are filed pursuant to Item 8 of this Report:

Index to Consolidated Financial Statements

<TABLE>
<CAPTION>
                                                                                          Page
                                                                                          ----
       <S>                                                                                <C>
       Consolidated Financial Statements

       Report of Independent Auditors                                                     F-2


       Consolidated Balance Sheets as of March 31, 2001 and 2000                          F-3

       Consolidated Statements of Operations for the years ended March 31, 2001,
         2000 and 1999                                                                    F-4

       Consolidated Statements of Shareholders' Equity for the
         years ended March 31, 2001, 2000 and 1999                                        F-5

       Consolidated Statements of Cash Flows for the years ended March 31, 2001,
         2000 and 1999                                                                    F-6

       Notes to Consolidated Financial Statements                                         F-7

       Consolidated Financial Statement Schedules

       Schedule II - Valuation and Qualifying Accounts                                    F-20
</TABLE>

     All other consolidated financial statement schedules for which provision is
made in the applicable accounting regulations of the Securities and Exchange
Commission are not required pursuant to the instructions to Item 8 or are
inapplicable and therefore have been omitted.


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

   None

                                       32
<PAGE>

                                   PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The sections entitled "Election of Directors" and "Section 16(a) Beneficial
Ownership Reporting Compliance" appearing in our proxy statement for the annual
meeting of shareholders to be held on or about September 5, 2000 (the "2001
Proxy Statement"), set forth certain information with respect to the directors
of Data Return and with respect to reporting under Section 16(a) of the
Securities Exchange Act of 1934, and are incorporated herein by reference.

     Certain information with respect to the executive officers of Data Return
is set forth under the caption "Executive Officers of the Registrant" in Part I
of this report.

ITEM 11.  EXECUTIVE COMPENSATION

     The section entitled "Executive Compensation" appearing in the 2001 Proxy
Statement sets forth certain information with respect to the compensation of our
management, and, except for the report of the compensation committee of the
board of directors of Data Return on executive compensation and the information
therein under "Performance Graph," is incorporated herein by reference.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The sections entitled "Security Ownership of Certain Beneficial Owners" and
"Security Ownership of Management" appearing in the 2001 Proxy Statement set
forth certain information with respect to the ownership of voting securities and
equity securities of Data Return, and are incorporated herein by reference.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     Not applicable.


                                    PART IV

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

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

          (1)  A list of the financial statements and the schedule filed as a
               part of this report is set forth in Item 8 on page 32 and is
               incorporated herein by reference.

               All other schedules are omitted because they are either not
               applicable or required information is shown in the financial
               statements or notes thereto.

          (2)  Exhibits:

<TABLE>
<CAPTION>
   Exhibit
   Number      Description
   ------      -----------
   <S>         <C>
   3.1(1)      Amended and Restated Articles of Incorporation of the Registrant to be filed just prior to
               effectiveness of this Registration Statement.
   3.2(1)      Amended and Restated Bylaws of the Registrant
   4.1(1)      Form of Common Stock Certificate
   4.2(1)      Common Stock Warrant between Data Return Corporation and Microsoft Corporation.
   4.3(1)      Rights Agreement by and between Data Return Corporation and ChaseMellon
               Shareholder Services, LLC, as rights agent.
  10.1(1)      Strategic Marketing and Sales Agreement dated July 1, 1999, by and between Data Return
</TABLE>

                                       33
<PAGE>

<TABLE>
 <S>           <C>
               Corporation and Level 3 Communications, LLC.
   10.2(1)     Restricted Stock Purchase Agreement dated July 23, 1999, by and between Data Return
               Corporation and Level 3 Communications, LLC.
   10.3(1)     Service Credit Agreement dated July 23, 1999, by and between Data Return Corporation and
               Level 3 Communications, LLC.
   10.4(1)     Customer Order dated April 28, 1999, executed by Data Return Corporation and Level 3
               Communications, LLC
   10.5(1)     Managed Services Proposal for Data Return dated March 6, 1997, by and between Data Return
               Corporation and American Communications Services, Inc.
   10.6(1)     Basic Internet Services Agreement dated December 12, 1997, between Data Return Corporation
               and Savvis Communications Enterprises, L.L.C.
   10.7(4)     Promissory Note to BankOne Texas, National Association dated July 31, 2000.
   10.8(4)     FIRST AMENDMENT TO CREDIT AGREEMENT dated as of July 31, 2000, by and between DATA RETURN
               CORPORATION and BANK ONE, TEXAS, NATIONAL ASSOCIATION.
   10.9(1)*    1999 Long-Term Incentive Plan
  10.10(1)*    1998 Stock Option Plan
  10.11(1)*    Employment Agreement effective as of May 3, 1998, between Data Return Corporation and J. Todd
               Steitle.
  10.12(1)*    Employment Agreement dated March 18, 1999, between Data Return Corporation and Kenneth S.
               Garber.
  10.13(1)*    Employment Agreement effective as of January 15, 1998, between Data Return Corporation and
               Michael S. Shiff.
  10.14(1)*    Form of Employment Agreement dated July 1, 1999 between Data Return Corporation and each of
               Sunny C. Vanderbeck, Michelle R. Chambers, Jason A. Lochhead, Stuart A. Walker, Robert A. Prosen,
               Mark A. Bowles, Scott W. Brewer, Mark C. Gunnin and Mark A. Warren.
  10.15(1)     Sublease dated June 28, 1999, between Data Return Corporation and Eastman Kodak Company,
               for approximately 22,663 square feet situated at 222 Las Colinas Boulevard in Irving, Texas.
  10.16(1)     Investor's Rights Agreement dated as of July 29, 1999, between Data Return Corporation and
               CPQ Holdings, Inc.
  10.17(1)     ASP and Server Agreement dated June 29, 1999, between Data Return Corporation and Compaq
               Computer Corporation.
  10.18(1)     Development, License and Co-Marketing Agreement dated September 3, 1999, between Data
               Return Corporation and Microsoft Corporation.
  10.19(1)     Stock Purchase Agreement dated September 2, 1999, between Data Return Corporation and
               Microsoft Corporation.
  10.20(2)     Credit Agreement dated December 29, 1999 between Data Return Corporation and Bank One, Texas,
               N.A.
  10.21(2)     Promissory Note dated December 29, 1999 to Bank One, Texas, N.A.
  10.22(3)     Office Lease entered into as of November 15, 1999, by and between 114 MILLENNIUM, LTD. and Data
               Return Corporation
  10.23(3)     First Amendment to Office Lease dated as of February 15, 2000, by and between 114 MILLENNIUM,
               LTD. and Data Return Corporation
  10.24(3)     Second Amendment to Office Lease dated as of May 10, 2000, by and between 114 MILLENNIUM, LTD.
               and Data Return Corporation
   21.1(5)     Subsidiaries of the Registrant
   23.1(5)     Consent of Ernst & Young LLP
</TABLE>

____________
(1) Previously filed as an Exhibit to the Registrant's Registration Statement on
    Form S-1 (File No. 333-84011) and incorporated herein by this reference.
(2) Previously filed as an Exhibit to the Registrant's Quarterly Report on Form
    10-Q for the quarterly period ended December 31, 1999 and incorporated
    herein by this reference.
(3) Previously filed as an Exhibit to the Registrant's Annual Report on Form 10-
    K for the year ended March 31, 2000 and incorporated herein by this
    reference.

                                      34
<PAGE>

(4) Previously filed as an Exhibit to the Registrant's Quarterly Report on Form
    10-Q for the quarterly period ended September 30, 2000 and incorporated
    herein by this reference.
(5) Filed herewith.

*   Management contracts or compensatory plans required to be filed as an
    exhibit hereto.

(b) No reports on Form 8-K were filed by the Company during the quarter ended
    March 31, 2001.

                                       35
<PAGE>

                                  SIGNATURES

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

                                        Data Return Corporation



Date: June 28, 2001                By:  /s/ Sunny C. Vanderbeck
                                       ----------------------------------------
                                        Sunny C. Vanderbeck
                                        Chairman and Chief Executive Officer

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

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------
          Signature                Capacity in Which Signed                   Date
          ---------                ------------------------                   ----
--------------------------------------------------------------------------------------------
<S>                             <C>                                       <C>
                                 Chairman of the Board, Chief
                                Executive Officer and Director
   /s/ Sunny C. Vanderbeck       (Principal Executive Officer)            June 28, 2001
------------------------------
      Sunny C. Vanderbeck
--------------------------------------------------------------------------------------------


                                     President, and Director
   /s/ Michelle R. Chambers                                               June 28, 2001
------------------------------
      Michelle R. Chambers
--------------------------------------------------------------------------------------------
                                Vice President - Chief Technology
    /s/ Jason A. Lochhead              Officer and Director               June 28, 2001
------------------------------
       Jason A. Lochhead
--------------------------------------------------------------------------------------------
                                 Senior Vice President - Chief
                                     Financial Officer and
                                Treasurer (Principal Financial
    /s/ Stuart A. Walker            and Accounting Officer)               June 28, 2001
------------------------------
      Stuart A. Walker
--------------------------------------------------------------------------------------------


     /s/ Joseph M. Grant                   Director                       June 28, 2001
------------------------------
        Joseph M. Grant
--------------------------------------------------------------------------------------------

  /s/ Robert Ted Enloe, III                Director                       June 28, 2001
------------------------------
     Robert Ted Enloe, III
--------------------------------------------------------------------------------------------
</TABLE>

                                       36
<PAGE>

                            DATA RETURN CORPORATION

                  Index to Consolidated Financial Statements

                                                                          Page
                                                                          ----
     Consolidated Financial Statements

     Report of Independent Auditors                                        F-2

     Consolidated Balance Sheets as of March 31, 2001 and 2000             F-3

     Consolidated Statements of Operations for the
      years ended March 31, 2001, 2000 and 1999                            F-4

     Consolidated Statements of  Shareholders' Equity for the
      years ended March 31, 2001, 2000 and 1999                            F-5

     Consolidated Statements of  Cash Flows for the
      years ended March 31, 2001, 2000 and 1999                            F-6

     Notes to Consolidated Financial Statements                            F-7

     Consolidated Financial Statement Schedule

     Schedule II - Valuation and Qualifying Accounts                       F-20

     All other consolidated financial statement schedules for which provision is
made in the applicable accounting regulations of the Securities and Exchange
Commission are not required pursuant to the instructions to Item 8 or are
inapplicable and therefore have been omitted.

                                      F-1
<PAGE>

                        Report of Independent Auditors


The Board of Directors and Stockholders
Data Return Corporation


We have audited the accompanying consolidated balance sheets of Data Return
Corporation as of March 31, 2001 and 2000, and the related consolidated
statements of operations, shareholders' equity and cash flows for each of the
three years in the period ended March 31, 2001.  Our audits also included the
financial statement schedules listed in the Index at Item 14.  These financial
statements and schedule are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these financial statements and
schedules based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the 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 consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Data
Return Corporation at March 31, 2001 and 2000, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended March 31, 2001, in conformity with accounting principles generally
accepted in the United States.  Also in our opinion, the related financial
statement schedules, when considered in relation to the basic financial
statements taken as a whole, present fairly in all material respects the
information set forth therein.

As discussed in Note 1 to the consolidated financial statements, in fiscal 2001
the Company changed it's method of accounting for revenue recognition for set-up
fees.



                                          /s/ Ernst & Young LLP


Dallas, Texas
June 22, 2001

                                      F-2
<PAGE>

                            DATA RETURN CORPORATION
                          Consolidated Balance Sheets
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                                              March 31,
                                                                                   -------------------------------
                                                                                     2001                  2000
                                                                                   --------              ---------
<S>                                                                                <C>                   <C>
Assets
Current assets:
     Cash and equivalents                                                          $  6,566              $  85,424
     Investment in available-for-sale securities                                     26,800                      -
     Accounts receivable, net of allowance for doubtful accounts
         of $1,589 and $328 at March 31, 2001 and
         2000, respectively                                                           8,477                  5,429
     Prepaid expenses and other assets                                                1,189                  1,349
                                                                                   --------              ---------
Total current assets                                                                 43,032                 92,202
     Property and equipment, net                                                     44,104                 22,027
     Other assets                                                                       496                    628
                                                                                   --------              ---------
Total assets                                                                       $ 87,632              $ 114,857
                                                                                   ========              =========
Liabilities and shareholders' equity
Current liabilities:
     Accounts payable                                                              $  2,443              $   2,021
     Accrued expenses and other                                                       4,265                  2,205
     Deferred revenue                                                                 5,717                  2,207
     Capital lease obligations and notes payable - current                           12,873                  5,799
                                                                                   --------              ---------
Total current liabilities                                                            25,298                 12,232

Capital lease obligations and notes payable - long term                              18,173                 11,324
Commitments and contingencies                                                             -                      -
Shareholders' equity:
     Preferred stock, $.001 par value; 20,000 shares
         authorized, none issued or outstanding                                           -                      -
     Common stock, $.001 par value; 100,000 shares
         authorized; 35,979 and 35,398 issued and outstanding
         at March 31, 2001 and 2000, respectively                                        36                     35
     Additional paid-in capital                                                     110,497                109,718
     Prepaid broadband services                                                      (4,594)                (5,000)
     Deferred stock compensation                                                       (119)                  (290)
     Accumulated other comprehensive income                                             281                      -
     Accumulated deficit after comprehensive income                                 (61,940)               (13,162)
                                                                                   --------              ---------
Total shareholders' equity                                                           44,161                 91,301
                                                                                   --------              ---------
Total liabilities and shareholders' equity                                         $ 87,632              $ 114,857
                                                                                   ========              =========
</TABLE>

         See accompanying notes to consolidated financial statements.

                                      F-3
<PAGE>

                            DATA RETURN CORPORATION
                     Consolidated Statements of Operations
                     (in thousands, except per share data)

<TABLE>
<CAPTION>
                                                                                        Year Ended March 31,
                                                                            --------------------------------------------
                                                                                2001              2000            1999
                                                                            ----------        ----------       ---------
<S>                                                                         <C>               <C>              <C>
Revenues                                                                    $   50,068        $   11,833       $   1,889

Costs and expenses:
      Cost of revenue                                                           45,444             9,277           1,105
      General and administrative                                                23,418             7,575           1,061
      Selling and marketing                                                     24,492             6,212             663
      Product research and development                                           4,778               548               2
      Stock-based compensation                                                     171             1,779             349
                                                                            ----------        ----------       ---------
Total costs and expenses                                                        98,303            25,391           3,180
                                                                            ----------        ----------       ---------
Loss from operations                                                           (48,235)          (13,558)         (1,291)
Other income (expense):
      Interest income                                                            3,749             2,191              20
      Interest expense                                                          (2,658)             (321)            (13)
      Other expense, net                                                            (8)               --              --
                                                                            ----------        ----------       ---------

Loss before cumulative effect of change in accounting principle                (47,152)          (11,688)         (1,284)
Cumulative effect of change in accounting principle                             (1,626)               --              --
                                                                            ----------        ----------       ---------

Net loss                                                                    $  (48,778)       $  (11,688)      $  (1,284)
                                                                            ==========        ==========       =========

Basic and diluted net loss per common share:
      Before cumulative effect of change in accounting principle            $    (1.32)       $    (0.40)      $   (0.07)
      Cumulative effect of change in accounting principle                   $    (0.05)       $       --       $      --
                                                                            ----------        ----------       ---------

      Net loss per common share                                             $    (1.37)       $    (0.40)      $   (0.07)
                                                                            ==========        ==========       =========
</TABLE>


Pro forma amounts, assuming the accounting change is applied retroactively:

<TABLE>
<S>                                                                         <C>               <C>              <C>
Net loss..........................................                          $  (47,152)       $  (13,182)      $  (1,385)
                                                                            ==========        ==========       =========
Net loss per common share.........................                          $    (1.32)       $    (0.45)      $   (0.08)
                                                                            ==========        ==========       =========

Shares used in computing basic and
 diluted net loss per share.......................                              35,712            29,268          18,371
                                                                            ==========        ==========       =========
</TABLE>

         See accompanying notes to consolidated financial statements.

                                     F-4
<PAGE>

                            DATA RETURN CORPORATION
                Consolidated Statements of Shareholders' Equity
                       (in thousands, except share data)

<TABLE>
<CAPTION>

                                                                   Note                           Accumulated
                                      Common Stock   Additional Receivable  Prepaid    Deferred      Other                   Share
                                   ----------------    Paid-In  for Shares Broadband     Stock    Comprehensive Accumulated holders'
                                    Shares    Amount   Capital    Issued   Services  Compensation    Income       Deficit    Equity
                                    ------   -------   -------    ------   --------  ------------   -------       -------    ------
<S>                               <C>        <C>     <C>        <C>        <C>       <C>          <C>           <C>        <C>
Balance--March 31, 1998.......... 17,592,600   $  18   $  2,318    $(500)  $    --      $(1,216)    $    --     $    (190) $    430
Issuance of common stock.........  2,959,000       3      1,247      500        --           --          --            --     1,750
Deferred compensation related
 to stock options................         --      --        328       --        --         (328)         --            --        --
Amortization of deferred stock
 compensation....................         --      --         --       --        --          349          --            --       349
Net loss.........................         --      --         --       --        --           --          --        (1,284)   (1,284)
                                  ----------   -----   --------    -----   -------      -------     -------   -----------  --------
Balance--March 31, 1999.......... 20,551,600      21      3,893       --        --       (1,195)         --        (1,474)    1,245
Issuance of common stock......... 12,893,464      12     99,775       --        --           --          --            --    99,787
Deferred compensation related
 to stock options................         --      --        874       --        --         (874)         --            --        --
Amortization of deferred stock
 compensation....................         --      --         --       --        --        1,779          --            --     1,779
Issuance of common stock for
 broadband services..............  1,952,940       2      4,998       --    (5,000)          --          --            --        --
Amortization of cost of
 warrants issued for services....         --      --        178       --        --           --          --            --       178

Net loss.........................         --      --         --       --        --           --          --       (11,688)  (11,688)
                                  ----------   -----   --------    -----   -------      -------     -------   -----------  --------
Balance--March 31, 2000.......... 35,398,004      35    109,718       --    (5,000)        (290)         --       (13,162)   91,301
Issuance of common stock.........    580,940       1        225       --        --           --          --            --       226
Amortization of deferred stock
 compensation....................         --      --         --       --        --          171          --            --       171
Application of credits for
 broadband services..............         --      --         --       --       406           --          --            --       406
Amortization of warrants issued
 for services....................         --      --        554       --        --           --          --            --       554
Unrealized gains on  available-
 for-sale securities.............         --      --         --       --        --           --         281            --       281
Net loss.........................         --      --         --       --        --           --          --       (48,778)  (48,778)
                                  ----------   -----   --------    -----   -------      -------     -------   -----------  --------
Balance--March 31, 2001.......... 35,978,944   $  36   $110,497    $  --   $(4,594)     $  (119)    $   281   $   (61,940)   44,161
                                  ==========   =====   ========    =====   =======      =======     =======   ===========  ========
</TABLE>

          See accompanying notes to consolidated financial statements

                                      F-5
<PAGE>

                            DATA RETURN CORPORATION
                     Consolidated Statements of Cash Flows
                                (in thousands)

<TABLE>
<CAPTION>

                                                                                                     Year Ended March 31

                                                                                          ------------------------------------------
                                                                                           2001             2000             1999
                                                                                         --------         --------         --------
Operating activities:
<S>                                                                                      <C>              <C>              <C>
Net Loss                                                                                 $(48,778)        $(11,688)        $ (1,284)

Adjustment to reconcile net loss to net cash used in operations:
   Noncash items included in net loss:
             Depreciation                                                                  14,082            2,036              129
             Amortization                                                                     881               --               --
             Stock based compensation expense                                                 171            1,779              349
             Provision for bad debts                                                        3,547              526               40
             Amortization of warrants issued for services                                     554              178               --
             Loss on disposal of assets                                                        63               --               --
   Changes in operating assets and liabilities:
             Accounts receivable                                                           (6,595)          (5,579)            (317)
             Prepaids and other assets                                                        573           (1,931)             (23)
             Accounts payable and accrued expenses                                          2,887            3,803              252
             Deferred revenue                                                               3,510            1,921              209
                                                                                         --------         --------         --------

Net cash used in operations                                                               (29,105)          (8,955)            (645)

Investing activities:
             Capital expenditures                                                         (13,415)          (5,953)            (814)
             Purchase of available-for-sale securities                                    (37,889)              --               --
             Proceeds from available-for-sale securities                                   11,089               --               --
             Restricted cash                                                                   --              125             (125)
                                                                                         --------         --------         --------
Net cash used in investing activities                                                     (40,215)          (5,828)            (939)

Financing activities:
             Proceeds from notes payable                                                       --              804              250
             Payments on notes payable and capital lease obligations                       (9,764)          (1,227)             (47)
             Net proceeds from issuance of common stock                                       226           99,787            1,750
                                                                                         --------         --------         --------
Net cash (used in) provided by financing activities                                        (9,538)          99,364            1,953

Net (decrease) increase in cash                                                           (78,858)          84,581              369

             Beginning cash                                                                85,424              843              474
                                                                                         --------         --------         --------
             Ending cash                                                                 $  6,566         $ 85,424         $    843
                                                                                         ========         ========         ========
Supplemental disclosure of cash flows information:
             Cash paid for interest                                                      $  2,950         $    204         $     11
                                                                                         ========         ========         ========
Non cash activities:
             Deferred compensation                                                       $     --         $    874         $    328
                                                                                         ========         ========         ========
             Equipment acquired under capital lease                                      $ 23,686         $ 17,232         $     51
                                                                                         ========         ========         ========
             Warrants to acquire common stock issued
                   for services                                                          $     --         $  2,225         $     --
                                                                                         ========         ========         ========
             Common stock issued for broadband services                                  $     --         $  5,000         $     --
                                                                                         ========         ========         ========
</TABLE>

         See accompanying notes to consolidated financial statements.

                                      F-6
<PAGE>

                            DATA RETURN CORPORATION

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                   Years Ended March 31, 2001, 2000 and 1999

1.  Organization, Basis of Presentation and Significant Accounting Policies

Organization

  Data Return Corporation (the "Company") was incorporated in August 1997 under
the laws of the State of Texas and commenced operations on September 22, 1997
(inception). The Company primarily provides advanced Microsoft Internet hosting
services to businesses, web site developers, application service providers, and
other organizations. The Company's advanced Microsoft hosting services enable
its customers to establish and maintain e-commerce and other applications
through which they can conduct transactions and manage information on a
worldwide basis over the Internet.

  The Company's computer equipment, principally servers, is primarily located in
separate facilities owned by one of its vendors. The vendor provides data center
facilities and bandwidth connectivity to the Company on a contractual basis.

  The Company closed completed its initial public offering of common stock on
November 4, 1999.  The Company sold 7,187,500 shares of common stock to the
public, including the underwriters' overallotment, and received net proceeds of
$85.9 million

  The Company believes that its current cash and investment balances should be
sufficient to meet its working capital and capital expenditure requirements
through March 31, 2002. The Company will continue to incur negative cash flows
during fiscal 2002 and thereafter. Therefore, it will be required to use its
cash and other liquid resources to support its operations. If the Company does
not achieve the results of operations that it expects as a result of lower than
expected revenues, higher than expected expenses or other possible adverse
developments, then the Company would be required either to secure additional
sources of capital to continue operating at its current level or to curtail its
current operations. The Company's operating activities on a long-term basis may
require it to obtain additional equity or debt financing. The Company finances
under capital or operating leases substantially all of the equipment it uses to
provide services to its customers. As a result, the Company's investments in
this type of equipment will require it to obtain additional lease or other
financing in the future. If the Company requires additional financing for any
reason, there can be no assurance that such additional financing will be
available to it on acceptable terms, or at all. In the event the Company is
unable to raise additional capital, it may be required to substantially reduce
or curtail operations.

Significant Accounting Policies

 Principles of Consolidation

  The consolidated financial statements include the accounts of the Company and
its subsidiaries. All significant intercompany accounts and transactions have
been eliminated in consolidation.

 Use of Estimates

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

 Revenue Recognition

  Revenues are primarily derived from monthly recurring hosting service fees and
from set-up fees. Shared hosting services, in which more than one customer
shares the same server and typically generate $500 or less per month, do
not require a contract. Dedicated server offerings, in which each customer has
one or more servers that are dedicated for its use, More complex services
require a contract that is generally 12 to 24 months in length. Dedicated server
offerings include clustered configurations, in which we utilize two or more
dedicated servers to distribute content and functionality across multiple
servers or, in the case of multi-site clusters, across multiple data centers.
Revenues from these contracts are recognized ratably over the contractual period
as service is delivered. Payments received for billings in advance of providing
services are deferred until the period such services are provided.

                                      F-7
<PAGE>

                            DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(continued)

                   Years Ended March 31, 2001, 2000 and 1999

  Effective April 1, 2000, the Company changed its method of accounting for set-
up fee revenue in accordance with Staff Accounting Bulletin No. 101 ("SAB 101"),
Revenue Recognition in Financial Statements. Historically, the Company has
recognized set-up revenue, in accordance with industry practice, upon completion
of the deployment of the hardware and software used by the Company to provide
services installation of the managed Web hosting solution. The direct costs
associated with the installation are expensed as incurred. Under the new
accounting method adopted in January 2001 retroactive to April 1, 2000, the
Company now recognizes set-up revenue over the contract term, generally 12
months.  The Company continues to expense direct costs associated with set-up as
the costs are incurred.

  The cumulative effect of the change on prior years resulted in a net charge of
$1.62 million, which is included in the Consolidated Statement of Operations for
the year ended March 31, 2001. The effect of the change on the year ended March
31, 2001 was to decrease the net loss before the cumulative effect of the
accounting change by $408,000 ($0.01 per share). For the year ended March 31,
2001, the Company recognized revenue of $1.62 million that was included in the
cumulative effect adjustment as of April 1, 2000. With the adoption of SAB 101,
there was no economic impact to the Company's business operations or cash flow.
There was also no material effect to the Company's consolidated financial
statements. The pro forma amounts presented in the Consolidated Statements of
Operations were calculated assuming the accounting change was made retroactively
to prior periods.

 Concentrations of Credit Risk

  Financial instruments that potentially expose the Company to credit risk
consist primarily of cash, cash  and equivalents, available-for-sale securities
and accounts receivable. The Company places its cash, cash equivalents and
available-for-sale securities with reputable institutions.  The Company has not
experienced any losses in such accounts and does not believe it is exposed to
any significant credit risk with such respect to cash, cash equivalents and
available-for-sale securities.  Accounts receivable are due from commercial
entities to which credit is extended based on evaluation of the customer's
financial condition.  Anticipated credit losses are provided for in the
consolidated financial statements and have been within management's expectations
for all periods presented.

 Customer and Geographic Concentrations

  The Company's largest customer accounted for approximately 18% of total
revenues during the year ended March 31, 2001.  No other customers accounted for
greater than 10% of revenues for the years ended March 31, 2001, 2000 or 1999.

  Revenues from international customers were approximately $2,283,000, $516,000
and $189,000 for fiscal 2001, 2000 and 1999, respectively. The Company's
international revenues were primarily generated from customers located in Europe
and Canada. In fiscal 2001, revenues from customers located in Europe and Canada
accounted for approximately 2.2% and 1.7% of total revenues, respectively. Total
assets from international operations, comprised of accounts receivable, were
0.6% of total assets as of March 31, 2001.

 Cash and Equivalents

  Cash equivalents consist of highly liquid investments with original maturities
of 90 days or less.  As of March 31, 2001, cash equivalents consisted
principally of money market funds at several financial institutions.

 Available-for-Sale Securities

  Available-for-sale securities are comprised of debt securities for which there
is a determinable fair market value and for which there are no restrictions on
the Company's ability to sell the security. In

                                      F-8
<PAGE>

                            DATA RETURN CORPORATION
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

accordance with the provisions of SFAS No. 115, Accounting for Certain
Investments in Debt and Equity Securities, available-for-sale securities are
carried at fair value, with unrealized gains and losses reported as a separate
component of shareholders' equity. Realized gains and losses and declines in
value deemed to be other-than-temporary on available-for-sale securities are
included in other income. The cost basis for realized gains and losses on
available-for-sale securities is determined on a specific identification basis.

  At March 31, 2001, the realized gains on sales of available-for-sale
securities totaled $55,000.  The net adjustment of unrealized gains of $281,000
has been recorded as a separate component of shareholders' equity.  There were
no available-for-sale securities in fiscal years 2000 and 1999.

<TABLE>
<CAPTION>

                                                                                                 Unrealized          Unrealized
                                                               Amortized          Market          Holding             Holding
                                                                 Cost              Value            Gains              Losses
                                                             -------------      ----------      --------------      --------------
                                                                                        (in thousands)
<S>                                                          <C>                <C>             <C>                 <C>
March 31, 2001:
Corporate debt securities:
        Money market funds.............................      $       1,996      $    1,996      $            -      $            -
        Corporate bonds and notes......................             10,696          10,794                  98                   -
                                                             -------------      ----------      --------------      --------------
             Total corporate debt securities...........             12,692          12,790                  98                   -
Asset backed securities................................              5,129           5,196                  67                   -
U.S. government and government
   agency securities...................................              8,698           8,814                 116                   -
                                                             -------------      ----------      --------------      --------------

Total investment in available-for-sale securities......      $      26,519      $   26,800      $          281      $            -
                                                             =============      ==========      ==============      ==============
 </TABLE>

  The amortized cost and fair value of available-for-sale debt securities at
March 31, 2001, by contractual maturity, are shown below.  Expected maturities
may differ from contractual maturities as the issuers of the securities may have
the right to prepay obligations without prepayment penalties.

                                                                    Estimated
                                                   Cost             Fair Value
                                              --------------       ------------
                                                        (in thousands)

Due in one year or less                           $23,392            $23,602
Due after one year through three years              1,713              1,744
Due after three years                               1,414              1,454
                                                  -------            -------
                                                  $26,519            $26,800
                                                  =======            =======


 Property and Equipment

  Property and equipment is stated at cost. Depreciation is computed using the
straight-line method over estimated useful lives of the property and equipment,
generally three years for computer equipment and up to seven years for furniture
and fixtures. Equipment acquired under capital leases is amortized using the
straight-line method over the lesser of the lease term or the estimated useful
life of the asset, generally three years. The costs of software licenses are
amortized over the shorter of the term of the licenses or the

                                      F-9
<PAGE>

                           DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

estimated useful life of the software, generally two years. Leasehold
improvements are amortized over the shorter of the lease term or the estimated
useful life of the improvements.

  The Company capitalizes certain costs incurred for the development of internal
use software.  These costs include the costs associated with coding, software
configuration, upgrades and enhancements.   Software is amortized over its
estimated useful life, generally two years.

 Impairment of Long-Lived Assets

  In accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of, the Company reviews its
long-lived assets for impairment when events or changes in circumstances
indicate the carrying value of such assets may not be recoverable. This review
consists of a comparison of the carrying value of the asset with the asset's
expected future undiscounted cash flows without interest costs. Estimates of
expected future cash flows represent management's best estimate based on
reasonable and supportable assumptions and projections. If the expected future
cash flow exceeds the carrying value of the asset, no impairment indicator is
considered present. If the carrying value exceeds the future cash flow, an
impairment indicator is considered present. Such impairment would be measured
and recognized using a discounted cash flow method.

 Fair Value of Financial Instruments

  The carrying amount of cash equivalents approximates fair value due to the
short-term maturities of these instruments.  Management believes the carrying
amount of capital leases and notes payable are not materially different from the
estimated fair value based on prevailing interest rates for similar financial
instruments.

  Available-for-sale securities consist of investments in debt securities and
are stated at fair market value as determined by quoted market prices. Gross
unrealized gains, which have been included as a separate component of
shareholders' equity, were $281,000 at March 31, 2001. No unrealized holding
gains or losses were recognized during the years ended March 31, 2000 and 1999.

 Advertising Costs

  The Company expenses advertising costs as incurred. Advertising expense
amounted to $3,413,000,  $661,000, and $296,000 for the years ended March 31,
2001, 2000 and 1999, respectively.

 Stock-based Compensation

  In October 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based
Compensation.  SFAS 123 defines a fair-value based method of accounting for an
employee stock option or similar equity instrument. As permitted by SFAS 123,
the Company has elected to continue to measure the cost of its stock-based
compensation plans using the intrinsic-value based method of accounting
prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees.

 Income Taxes

  Deferred income taxes are provided for the tax effects of differences between
the carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for income tax purposes.  Valuation reserves are provided
for the deferred tax assets when it is more likely than not that the deferred
tax assets will not be realized.

                                      F-10
<PAGE>

                           DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

 Segment Reporting

  Under Statement of Financial Accounting Standards No. 131 (SFAS 131),
Disclosures about Segments of an Enterprise and Related Information, the Company
operated, for all periods presented, in a single segment.

 Recent Accounting Pronouncements

  In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivative
Instruments and Hedging Activities. SFAS 133 is effective for the Company April
1, 2001. SFAS 133, as amended, requires that all derivative instruments be
recorded on the balance sheet at fair value. Changes in the fair value of
derivatives are recorded each period in current earnings or other comprehensive
income, depending on whether a derivative is designated as part of a hedge
transaction and the type of hedge transaction. The ineffective portion of all
hedges will be recognized in earnings.  Adoption of this standard is not
expected to have a significant impact on the Company's financial position,
results of operations or cash flows.

 Net Loss Per Share

  Net loss per share is computed using the weighted average number of shares of
common stock outstanding during each period for basic and diluted earnings per
share. Common stock equivalents are not  considered in the calculation of
diluted earnings per share as the Company has incurred a loss for all periods
presented and the effect of common stock equivalents would be anti-dilutive.
Thus, the 8,896,493 employee stock options and warrants to acquire 345,910
shares of common stock are not included in the calculation.

 Reclassifications

  Certain reclassifications have been made to conform the prior year amounts to
the current year presentation.

2.    Property and Equipment

      Property and equipment consists of the following:

                                                           March 31,
                                                           ---------
                                                        (in thousands)
                                                       2001          2000
                                                       ----          ----
Electronics and computer equipment..............    $ 44,313      $ 20,910
Leasehold improvements..........................       5,767           586
Furniture and office equipment..................       4,592           792
Computer software...............................       3,961         1,397
Other depreciable assets........................       2,547           520
                                                    --------       -------
                                                      61,180        24,205
Less accumulated depreciation and amortization..     (17,076)       (2,178)
                                                    --------       -------
                                                    $ 44,104      $ 22,027
                                                    ========       =======

  Property and equipment includes assets acquired under capital leases,
principally computer equipment with a cost of $40,918,000 and $17,232,000 at
March 31, 2001 and 2000, respectively.  Related allowances for depreciation and
amortization are $11,337,000 and $1,121,000, respectively.

                                      F-11
<PAGE>

                            DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

3.  Accrued Expenses

    Accrued expenses consist of the following:


                                                        March 31,
                                                        ---------
                                                    (in thousands)
                                                   2001        2000
                                                   ----        ----

Accrued payroll................................   $1,700      $1,013
Marketing costs................................    1,306          --
Commissions....................................      137         184
Professional fees..............................      183         157
Other..........................................      939         851
                                                  ------      ------
                                                  $4,265      $2,205
                                                  ======      ======

4.  Notes Payable

    On December 29, 1999, the Company entered into a $2 million revolving
credit facility with Bank One, Texas, N.A. This credit facility matures on July
31, 2001 and outstanding balances accrue interest at the bank's base rate (8% at
March 31, 2001). As of March 31, 2001, there was no outstanding balance under
the facility, and no borrowings have occurred since entering into the agreement.
The facility is secured by certain equipment that was unencumbered as of the
date of the facility and all accounts receivable outstanding. Under certain
limited circumstances, the Company could be required to deposit cash with the
bank to secure the loan. The credit facility contains standard events of default
and other covenants.

    In October 1999, the Company entered into a credit agreement with an
insurance company to finance certain of its insurance obligations. The agreement
bears interest at a rate of 10.5% per annum and required payments of $69,000
monthly through September 2000. The balance of the note payable was zero and
$434,000 at March 31, 2001 and 2000, respectively.


5.  Shareholders' Equity

 Common Stock

    The Company has issued 5,705,964 shares of common stock to private
investors, including the transaction with Microsoft Corporation described below
and Compaq Computer Corporation, for net proceeds of $13.9 million. The Company
closed its initial public offering on November 4, 1999. The Company sold
7,187,500 shares of common stock to the public, including the underwriters'
overallotment, and received net proceeds of $85.9 million.

    Pursuant to a Stock Sales Agreement (the Agreement) dated February 20, 1998,
between the Company and a private investor, the Company sold 2,152,000 shares of
its common stock for $0.46 per share. The Agreement provided for the issuance of
the shares in return for $500,000 cash and a promissory note in the amount of
$500,000 that was repaid in February 1999.  The Agreement provided the investor
the right to acquire an additional 2,690,000 shares of the Company's common
stock during a specified period in 2001 for $0.37 per share and provided the
Company the right to require the investor to purchase the shares for a period
beginning in February 1999 through August 2001. In February of 1999, the Company
exercised its rights under the Agreement and sold 2,690,000 shares of its common
stock to the investor for $0.37 per share.

                                      F-12
<PAGE>

                            DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

     On July 26, 1999, Level 3 Communications, Inc. (Level 3) acquired 1,952,940
shares of the Company's common stock in exchange for a $5.0 million credit to be
applied to the purchase of future broadband services.  The Company has recorded
the prepaid broadband services acquired in the agreement as a contra equity
account.  The Company has begun applying credits against payments for services
in excess of the minimum purchases required under the Strategic Marketing and
Sales Agreement (See Note 6) beginning on January 1, 2001. The Company has a
limited right to reacquire the stock in the event that Level 3 fails to fulfill
its obligations under the Service Credit Agreement (See Note 6). The number of
shares subject to the Company's right to reacquire the stock will be reduced pro
rata in each quarter of calendar year 2001 by the greater of the credit applied
to future purchases of bandwidth or 25% of the total shares. The stock can be
reacquired by the Company at the original purchase price by the Company's
forgiveness of the remaining balance of the credit. In the event the Company's
right to reacquire the stock is exercised, Level 3 is required to pay the
Company $750,000, reduced ratably, based on the amount of bandwidth credit used
by the Company.  During the fourth quarter of fiscal 2001, 25% of the shares
acquired by Level 3 under this agreement (488,235 shares) vested.

     On October 28, 1999 the Company closed an equity transaction with
Microsoft. The Company issued 454,546 shares of its common stock and an
immediately exercisable five-year warrant to acquire an additional 340,910
shares of its common stock for $11 per share. The Company estimated the value of
the warrant to be $2.1 million using a Black-Scholes pricing model. The value of
the warrant is being amortized and recorded as additional paid-in capital over
the five year term of the Development, License and Co-Marketing Agreement (See
Note 6).

  Warrants

     In March 2000, the Company issued an immediately exercisable three-year
warrant to an advertising agency to acquire 5,000 shares of common stock at an
exercise price of $49.19 per share.  The warrant was valued at $25.19 per share
using a Black Sholes valuation model.  The value of this warrant has been
amortized and recorded as additional paid-in capital over the twelve-month term
of the agreement entered into with the advertising agency.

  Stock Split

     On September 10, 1999, the Board of Directors approved a 269-for-1 split of
the Company's common stock. All share and per share amounts have been
retroactively restated to reflect the effect of the stock split.

  Shareholder Rights Plan

     On September 27, 1999, the Board of Directors adopted a Shareholders'
Rights Plan (the Plan) and declared a dividend of one preferred stock purchase
right for each share of common stock. Each right entitles its registered holder
to purchase one one-hundredth of a share of newly designated series A junior
participating preferred stock at a purchase price of $100.00. The rights are
attached to and trade with shares of the Company's common stock, including
future issuances of common stock. The rights are not currently exercisable and
become exercisable upon the earlier to occur of (a) the public announcement that
a person or group of persons has acquired 15% or more of the Company's common
stock, except in connection with an offer approved by the Board of Directors, or
(b) the close of business on the tenth business day, or a later date determined
by the Board of Directors, after the commencement of, or announcement of an
intention to commence, a tender or exchange offer that would result in a person
or group of persons acquiring 15% or more of the Company's common stock. In the
event the rights become exercisable, each holder of a right (except the
Acquiring Person, as defined in the Plan) will have the right to receive shares
of the Company's common stock having a market value of two times the exercise
price of the right. Also, if the Company is

                                      F-13
<PAGE>

                            DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

acquired in a merger in which the Company is not the surviving corporation, or
there is a sale of 50% or more of the Company's assets or earning power, each
holder of a right may receive common stock of the acquiring company having a
market value equal to two times the exercise price of the right. The rights
expire September 27, 2009. Each share of series A junior participating preferred
stock has dividend, liquidation and voting rights equal to those of 100 shares
of the Company's common stock. The series A junior participating preferred stock
is not redeemable.

Stock-based Compensation Arrangements

     The Company's 1998 Stock Option Plan (the 1998 Plan) provides for the
issuance to employees of options to acquire 3,308,700 shares of common stock.
The options are to be issued at fair market value, as defined, and vest as
approved by the Board of Directors. Options generally expire 10 years from the
date of grant and generally expire 90 days after termination of employment. The
vesting period for options to acquire 1,392,575 shares of common stock
accelerated to the effective date of the registration statement filed by the
Company for the initial public offering of its common stock.

  1999 Long-Term Incentive Plan

     In July 1999, the Company adopted the 1999 Long-Term Incentive Plan (the
1999 Plan). The 1999 Plan provides for the issuance of up to 5,000,000 options
to acquire its common stock.

     The following table summarizes the stock option activity related to the
Company:

<TABLE>
<CAPTION>
                                                                                                  Weighted
                                                              Number of        Per Share          Average
                                                               Shares       Exercise Price     Exercise Price
                                                               ------       --------------     --------------
<S>                                                           <C>           <C>                <C>
Outstanding options--September 22, 1997..................              --    $          --         $       --
     Granted.............................................       3,577,700             0.02               0.02
                                                              -----------    -------------     --------------

Outstanding options--March 31, 1998......................       3,577,700             0.02               0.02
     Granted.............................................       1,069,275        0.08-0.17               0.15
                                                              -----------    -------------     --------------

Outstanding options--March 31, 1999......................       4,646,975        0.02-0.17               0.05
     Granted.............................................       2,913,554       0.19-84.81              11.24
     Forfeited...........................................        (128,740)      0.23-58.13               4.17
                                                              -----------    -------------     --------------

Outstanding options-- March 31, 2000.....................       7,431,789       0.02-84.81               4.37
     Granted.............................................       2,749,080       2.88-38.25              17.48
     Exercised...........................................        (580,940)       0.02-2.56               0.39
     Forfeited...........................................        (613,436)      0.17-70.13              18.58
                                                              -----------    -------------     --------------

Outstanding options-- March 31, 2001.....................       8,986,493       0.02-84.81               7.67
                                                              ===========
Options exercisable--March 31, 2001......................       5,355,918       0.02-84.81               1.81
                                                              ===========
</TABLE>

The weighted-average fair value of options granted during the years ended March
31, 2001, 2000 and 1999 was  $16.95, $7.24, and $ 0.32, respectively.

                                     F-14
<PAGE>

                            DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

  The following table summarizes information about stock options outstanding as
of March 31, 2001:

<TABLE>
<CAPTION>
                                        Weighted Average                                              Weighted
    Range of            Shares              Remaining         Weighted Average        Number          Average
 Exercise Prices      Outstanding       Contractual Life       Exercise Price       Exercisable    Exercise Price
 ---------------      -----------       ----------------       --------------      ------------    --------------
<S>                   <C>               <C>                    <C>                 <C>             <C>
 $0.02 - $ 0.02         3,408,250                   6.80               $ 0.02           3,401,525          $ 0.02
 $0.08 - $ 1.31         1,877,890                   7.96               $ 0.28           1,524,731          $ 0.20
 $1.66 - $18.94         1,967,142                   9.09               $ 8.34             321,329          $10.54
 $19.5 - $84.81         1,733,211                   9.08               $29.96             108,333          $54.78
                        ---------                                                       ---------
                        8,986,993                                                       5,355,918
                        =========                                                       =========
</TABLE>

     Certain employees of the Company have been granted options under the 1998
Plan to purchase shares of the Company's common stock at less than fair market
value. Under a separate plan, an employee was granted 3,308,700 options that
vest over 4 years at a price below fair market value. The vesting period for the
3,308,700 options accelerated to the effective date of the registration
statement filed by the Company. The Company recorded deferred stock compensation
of zero, $874,000 and $328,000 for the years ended March 31, 2001, 2000 and
1999, respectively, for the difference between the exercise price and the deemed
fair value of the Company's common stock underlying certain options granted.
These amounts are being amortized over the vesting period of the individual
options, generally four years. The stock compensation expense charged to income
amounted to $171,000, $1,852,000 and $349,000 for the years ended March 31,
2001, 2000 and 1999, respectively.

     At March 31, 2001, there were 1,776,395 shares reserved for issuance under
the Company's option plans.

     As discussed in Note 1, the Company accounts for its stock-based awards to
employees using the intrinsic value method in accordance with APB Opinion No.
25, "Accounting for Stock Issued to Employees," and its related interpretations.

     SFAS No. 123 requires the disclosure of pro forma net loss and net loss per
share as if the Company had adopted the fair value method since September 22,
1997 (inception). Under SFAS No. 123, the fair value of stock-based awards to
employees is calculated through the use of option pricing models, even though
such models were developed to estimate the fair value of freely tradable, fully
transferable options without vesting restrictions, which significantly differ
from the Company's stock option awards. These models also require subjective
assumptions, including future price volatility and expected time to exercise,
which greatly affect the calculated values.  The Company's calculations for
determining the fair value of employee option grants were made using the Black-
Scholes Single Option Method using the following weighted average
assumptions:

                                          Years Ended March 31
                                        2001     2000       1999
                                        ------------------------
          Expected life                 8.6      5.0        4.0
          Risk-free interest rate       5.7%     6.3%       6.0%
          Volatility factor             1.4      0.8        0.0
          Dividend rate                 0.0%     0.0%       0.0%

                                      F-15
<PAGE>

                            DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

Had compensation cost been determined in accordance with SFAS No. 123 for all of
the Company's stock-based compensation plans, net loss attributable to holders
of common stock and net loss per share would have been changed to the amounts
indicated below (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                             Years Ended March 31,
                                                          2001        2000        1999
                                                      --------------------------------
       <S>                                            <C>         <C>          <C>
     Net loss applicable to common shareholders:
       As reported:                                   ($48,778)   ($11,688)    ($1,284)
     Pro Forma:                                       ($63,252)   ($14,643)    ($1,375)
     Basic and diluted net loss per share:
       As reported:                                     ($1.37)     ($0.40)     ($0.07)
       Pro Forma:                                       ($1.77)     ($0.50)     ($0.07)
 </TABLE>

6.   Significant Contracts

  Level 3 Agreements

     The Company entered into a Strategic Marketing and Sales Agreement (the
Agreement) with Level 3 on July 1, 1999.  The Strategic Marketing and Sales
Agreement provides that the Company will acquire most of its requirements for
co-location space, technical assistance, broadband service and private line
service (collectively, the Services) from Level 3 over a five-year period
commencing with the date of the Agreement.  The Company is also required to
purchase at least an additional $8.3 million of bandwidth and colocation
services over the next four years.  The quarterly commitment is $300,000 per
quarter through July 2001, $400,000 per quarter during the next 12 months,
$600,000 per quarter during the next 12 months and $1.0 million per quarter
during the final 12 months of the agreement.  The prices the Company will pay
Level 3 for the Services over the term of the Agreement are based upon Level 3's
then-current prices to other companies purchasing similar quantities. Management
believes adequate alternative sources of the Services are available.  Payments
for the minimum annual purchase commitments will be required regardless of
whether the Company uses the Services.

     The Company entered into a Service Credit Agreement on July 23, 1999. Under
the Service Credit Agreement, Level 3 acquired 1,952,940 shares of the Company's
stock in exchange for a $5.0 million credit. On January 1, 2001, the Company
became eligible to apply the $5.0 million credit to purchases in excess of the
minimum annual commitments required by the Strategic Marketing and Sales
Agreement. As of March 31, 2001, the Company applied for a $406,000 credit,
which was credited to the Company in May, 2001. Pricing of the services provided
and paid for with the credit will be based on Level 3's established market
prices at the time the service is provided.

  Microsoft Agreements

     On September 3, 1999, the Company entered into a five-year Development,
License and Co-Marketing Agreement with Microsoft Corporation (See Note 5).
Under the agreement, the Company delivered proprietary installation tools for
three specific applications that are used on Microsoft NT.  Modifications to the
tools will be cross-licensed between Data Return and Microsoft.  The Company
also trained Microsoft's employees and customers in the use of the tools.
Microsoft has the sole right to terminate the agreement if the Company fails to
deliver the tools on a timely basis or if the Company fails to correct any
errors in the tools on a timely basis.  Also as part of the agreement, Microsoft
provided one hundred hours of technical consulting and writing services during
the development of the tools.  Microsoft has the right to review certain
installation tools that the Company may develop over the next five years and to
receive a percentage of any revenues earned from the licensing or exploitation
of those tools.

                                      F-16
<PAGE>

                            DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

  ASP and Server Agreement

     In connection with a $3.0 million equity investment by Compaq, the Company
entered into a three-year agreement in July 1999 to acquire the lesser of 2,000
servers or the number of servers reasonably necessary to operate the Company's
business. At March 31, 2001, approximately 1,800 servers had been acquired under
this agreement. The requirement to purchase the servers is contingent upon
Compaq providing financing for the servers on competitive terms, upon the price,
performance and quality of the servers being reasonably satisfactory to the
Company and upon Compaq's commitment to deliver these servers on the schedule
the Company requests. The Company has purchased substantially all of its
computer hardware from Compaq. Management believes that adequate alternative
sources of computer hardware are available.

7.   Income Taxes

     At March 31, 2001, 2000 and 1999, the Company had temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and such amounts as measured by tax laws. Significant components of the
Company's deferred tax assets and liabilities were as follows:

<TABLE>
<CAPTION>
                                                                                March 31,
                                                                                ---------
                                                                              (in thousands)
                                                               2001                2000              1999
                                                               ----                ----              ----
<S>                                                          <C>                <C>                <C>
Deferred tax liability.................................      $      -           $   750            $     -
Deferred tax assets:
       Net operating loss carryforward.................      $ 18,908           $ 4,443            $   333
       Stock-based compensation........................         1,142               874                139
       Accrued expenses................................           855               124                 22
       Deferred revenue................................           599                 -                  -
       Allowance for bad debts.........................           588               122                  7
       Property and equipment..........................            66
       Other...........................................             4                 -                  -
                                                             --------           -------            -------
Total deferred tax assets..............................        22,162             5,563                501
       Less: valuation allowance.......................       (22,162)           (4,813)              (501)
                                                             --------           -------            -------
Deferred tax asset, net of valuation allowance.........      $      -           $   750            $     -
                                                             --------           -------            -------
       Net deferred tax asset (liability)............        $      -           $     -            $     -
                                                             ========           =======            =======
</TABLE>

     At March 31, 2001, the Company has approximately $51 million of federal net
operating loss carryforwards, which begin to expire in 2019.  The Company has
approximately $50 million of state net operating losses as of March 31, 20001.

     At March 31, 2001, the Company has recorded a valuation allowance against
its net deferred tax assets in accordance with SFAS 109 because management
believes that, after considering all the available objective evidence, it is
more likely than not that the deferred tax assets will not be realized.

                                     F-17
<PAGE>

                            DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999


8.   Commitments

  Leases

     The Company leases office space, office equipment, and revenue-generating
equipment under capital and operating leases. Future non-cancelable lease
payments under the Company's lease commitments at March 31, 2001 are as follows:

<TABLE>
<CAPTION>
                                                                              Operating      Capital
                                                                                Leases
                                                                              --------       -------
     <S>                                                                     <C>            <C>
     2002...............................................................      $ 4,095       $ 15,882
     2003...............................................................        4,041         15,158
     2004...............................................................        1,476          4,344
     2005...............................................................          899            356
     2006...............................................................          886              0
                                                                              -------       --------
     Total..............................................................      $11,397       $ 35,740
                                                                              =======
Less amount representing interest.......................................                      (4,694)
                                                                                            --------
Present value of lease payments.........................................                      31,046
Current portion of capital leases.......................................                     (12,873)
                                                                                            --------
Noncurrent portion of capital leases....................................                    $ 18,173
                                                                                            ========
</TABLE>

     The Company recorded rent expense of $3,631,000, $606,000, and $61,000 for
the years ended March 31, 2001, 2000 and 1999, respectively.

Bandwidth and CoLocation Agreements

     The Company has entered into agreements for bandwidth, colocation space
and dedicated Internet access with multiple vendors, primarily Level 3. Future
commitments for these services at March 31, 2001 are as follows:

     2002.....................................................   $ 3,806
     2003.....................................................     4,269
     2004.....................................................     5,095
     2005.....................................................     2,035
                                                                 -------
     Total                                                       $15,205
                                                                 =======

9.   Contingencies

     The Company may from time to time be subject to claims and litigation
arising from the normal course of its business operations.

     In January 2001, the Company entered into a guarantee with a financial
institution pursuant to which the Company guaranteed up to $5.0 million of the
margin debt of a Texas family limited partnership (an estate planning entity)
owned by Sunny C. Vanderbeck, the Chairman of the Board and Chief Executive
Officer of the Company. In June 2001, this guarantee was replaced with a new
guarantee that reduced the amount to $2.0 million. Based on a closing price of
$1.95 on June 22, 2001, the value of the collateral in the limited partnership's
account with this financial institution exceeded the amount of the margin debt
by approximately 50%.

     Pursuant to a letter agreement with the limited partnership and Mr.
Vanderbeck, if the Company is required to pay any amounts under the guarantee,
the limited partnership and Mr. Vanderbeck would be required to repay any
amounts paid by the Company under such guarantee. Mr. Vanderbeck and the Company
have also agreed to grant the Company a security interest in certain properties.
Mr. Vanderbeck and the limited partnership are required to take steps to reduce
the amount of the margin debt to a sufficient level to allow the guarantee to be
released as soon as reasonably practicable. The limited partnership also has
margin debt with another financial institution; however, based on a closing
price of $1.95 on June 22, 2001, the net assets of the limited partnership
exceed the amount of the guarantee by more than 100%.

10.  Subsequent Events

     On May 11, 2001, the Company reduced its workforce by 94 employees. The
reduction in workforce was a result of slower than anticipated growth and
increased process and other operational efficiencies. As a result of this
workforce reduction, the Company anticipates a one-time restructuring charge of
$1.0 million to $1.5 million in the first quarter of fiscal 2002. Giving effect
to this reduction, on May 12, 2001,

                                      F-18
<PAGE>

                            DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

our employee base consisted of the following: 194 in systems operations and
service and support, 90 in general and administrative functions, 110 in
marketing and sales and 49 in product research and development.

11.  Selected Quarterly Financial Data

The following is a summary of unaudited quarterly results of operations for the
years ended March 31, 2001 and 2000 (in thousands):

<TABLE>
<CAPTION>
                                                                     2001 (000's)
                                                    First Quarter                   Second Quarter
                                                    -------------                   --------------
                                             As previously  As restated        As previously  As restated
                                                reported      (1) (2)            reported          (1)
                                                --------      -------            --------          ---
<S>                                          <C>            <C>                <C>            <C>
Revenue                                      $    9,247     $    9,080         $   12,372     $    12,356
Net Loss before cumulative effect of
 accounting change                               (8,683)        (8,850)           (12,548)        (12,564)
Cumulative effect of accounting
 change                                               -         (1,626)                 -               -
Net loss                                         (8,683)       (10,476)           (12,548)        (12,564)
Loss per share before cumulative
 effect of accounting change                 $     0.24     $    (0.25)        $     0.35     $      0.35
Loss per share for cumulative effect
 of accounting change                                 -     $     0.05                  -               -
Loss per share                               $     0.24     $     0.30         $     0.35     $      0.35

<CAPTION>
                                                    Third Quarter                   Fourth Quarter
                                                    -------------                   --------------
                                             As previously  As restated
                                               reported         (1)
                                               --------         ---
<S>                                          <C>             <C>                    <C>
Revenue                                      $   14,063     $   14,246              $       14,386
Net Loss before cumulative effect of
 accounting change                              (13,055)       (12,872)                    (12,866)
Cumulative effect of accounting
 change                                               -              -                           -
Net loss                                        (13,055)       (12,872)                    (12,866)
Loss per share before cumulative
 effect of accounting change                 $     0.36     $     0.36              $         0.36
Loss per share for cumulative effect
 of accounting change                                 -              -                           -
Loss per share                               $     0.36     $     0.36              $         0.36
</TABLE>

<TABLE>
<CAPTION>
                                                                    2000 (000's)
                                                              Second                          Fourth
                                           First Quarter      Quarter     Third Quarter       Quarter
                                           -------------      -------     -------------       -------
<S>                                        <C>               <C>          <C>                <C>
Revenue                                     $     1,228      $  1,726     $      3,414       $  5,466
Net Loss before cumulative effect of
 accounting change                                 (638)       (1,922)          (4,033)        (5,098)
Net loss                                    $      (635)     $ (1,922)    $     (4,033)      $ (5,098)
Loss per share                              $     (0.03)     $  (0.07)    $      (0.12)      $  (0.14)
</TABLE>

     (1)  Restated for the effect of the implementation of SAB 101 (See Note 1).
     (2)  Of the $1,626,000 deferred on the implementation of SAB 101, $624,084,
          $524,911, $350,119 and $125,831 was recognized in revenue for the
          quarters ended June 30, 2000, September 30, 2000, December 31, 2000
          and March 31, 2001, respectively.

                                      F-19
<PAGE>

                            DATA RETURN CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                   Years Ended March 31, 2001, 2000 and 1999

                                  Schedule II

                       Valuation and Qualifying Accounts
                                 (In thousands)

<TABLE>
<CAPTION>

                                         Balance at         Charged to                         Balance at
                                         Beginning          Costs and                          End
        Description                      of Period          Expenses      Deductions           of Period
                                         ----------         ---------     ----------           ----------
<S>                                      <C>                <C>           <C>                  <C>
For the year ended March 31, 1999
  Deduct from asset accounts:
    Allowance for doubtful accounts         $     7          $    40          $    27 (1)         $    20

    Deferred tax valuation allowance             65              436                0                 501

For the year ended March 31, 2000
  Deduct from asset accounts:
    Allowance for doubtful accounts         $    20          $   592          $   284 (1)         $   327

    Deferred tax valuation allowance            501            4,312                0               4,813

For the year ended March 31, 2001
  Deduct from asset accounts:
    Allowance for doubtful accounts         $   327          $ 3,547          $ 2,285 (1)         $ 1,589
</TABLE>

     (1)  Uncollectible accounts written off, net of recoveries.

                                      F-20