##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 Form 10-Q þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  Commission File Number: 0-17932 Interland, Inc. (Exact name of registrant as specified in its charter)
 Minnesota
(State or other jurisdiction
of incorporation or organization)
    
    41-1404301
(I.R.S. Employer
Identification No.)
 303 Peachtree Center Avenue, Suite 500, Atlanta, GA 30303
(Address, including Zip Code, of principal executive offices) (404) 720-8301
(Registrants telephone number, including area code) Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
Registered on The Nasdaq National Market 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, and (2)
has been subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Act). Yes þ No o The number of outstanding shares of the registrants Common Stock on March 31, 2005 was 16,108,019.




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PART I. FINANCIAL INFORMATION
    
    
    3Item I. Financial Statements
    
    
    3Consolidated Statements of Operations
    
    
    3Consolidated Balance Sheets
    
    
    4Consolidated Statements of Cash Flows
    
    
    5Notes To Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion And Analysis Of Financial Condition And Results Of Operations
    
    
    12Item 3. Quantitative And Qualitative Disclosures About Market Risk
    
    
    24Item 4. Controls And Procedures
    
    
    24PART II.  OTHER INFORMATION
    
    
    25Item 1.
    
    Legal Proceedings
    
    
    25Item 2.
    
    Unregistered Sale of Equity Securities and Use of Proceeds
    
    
    27Item 3.
    
    Defaults Upon Senior Securities
    
    
    27Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    27Item 5.
    
    Other Information
    
    
    27Item 6.
    
    Exhibits
    
    
    27EX-31.1 SECTION 302, CERTIFICATION OF THE CEOEX-31.2 SECTION 302, CERTIFICATION OF THE CFOEX-32.1 SECTION 906, CERTIFICATION OF THE CEOEX-32.2 SECTION 906, CERTIFICATION OF THE CFO




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PART I. FINANCIAL INFORMATION 
 Item I. Financial Statements INTERLAND, INC. 
 Consolidated Statements of Operations 
 For the three months ended
    
    
    For the six months endedFebruary 28,
    
    
    February 29,
    
    
    February 28,
    
    
    February 29,2005
    
    
    2004
    
    
    2005
    
    
    2004Revenues
    
    $
    22,622
    
    
    $
    26,029
    
    
    $
    45,683
    
    
    $
    52,716Operating costs and expenses:Network operating costs, exclusive of depreciation
shown below
    
    
    5,304
    
    
    
    7,066
    
    
    
    10,989
    
    
    
    14,164Sales and marketing, exclusive of depreciation
shown below
    
    
    4,381
    
    
    
    6,535
    
    
    
    8,347
    
    
    
    11,741Technical support, exclusive of depreciation shown
below
    
    
    3,654
    
    
    
    4,641
    
    
    
    7,467
    
    
    
    9,446General and administrative, exclusive of
depreciation shown below
    
    
    7,706
    
    
    
    7,854
    
    
    
    14,837
    
    
    
    15,977Bad debt expense
    
    
    465
    
    
    
    935
    
    
    
    905
    
    
    
    2,066Depreciation and amortization
    
    
    5,306
    
    
    
    8,241
    
    
    
    11,184
    
    
    
    16,422Other expense (income), net
    
    
    72
    
    
    
    (48
    )
    
    
    59
    
    
    
    (73
    )Total operating costs and expenses
    
    
    26,888
    
    
    
    35,224
    
    
    
    53,788
    
    
    
    69,743Operating loss
    
    
    (4,266
    )
    
    
    (9,195
    )
    
    
    (8,105
    )
    
    
    (17,027
    )Interest income (expense), net
    
    
    83
    
    
    
    (166
    )
    
    
    124
    
    
    
    (304
    )Loss from continuing operations before taxes
    
    
    (4,183
    )
    
    
    (9,361
    )
    
    
    (7,981
    )
    
    
    (17,331
    )Income tax benefit (expense)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss from continuing operations
    
    
    (4,183
    )
    
    
    (9,361
    )
    
    
    (7,981
    )
    
    
    (17,331
    )Gain (loss) from discontinued operations, net of tax
    
    
    (89
    )
    
    
    (739
    )
    
    
    513
    
    
    
    (1,321
    )Net loss
    
    $
    (4,272
    )
    
    $
    (10,100
    )
    
    $
    (7,468
    )
    
    $
    (18,652
    )Net loss per share, basic and diluted:Continuing operations
    
    $
    (0.26
    )
    
    $
    (0.58
    )
    
    $
    (0.50
    )
    
    $
    (1.07
    )Discontinued operations
    
    
    (0.01
    )
    
    
    (0.04
    )
    
    
    0.03
    
    
    
    (0.08
    )$
    (0.27
    )
    
    $
    (0.62
    )
    
    $
    (0.47
    )
    
    $
    (1.15
    )Number of shares used in per share calculation:Basic and diluted
    
    
    16,026
    
    
    
    16,213
    
    
    
    16,021
    
    
    
    16,188
 The accompanying notes are an integral part of these consolidated financial statements.




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INTERLAND, INC. 
 Consolidated Balance Sheets 
 As ofFebruary 28,
    
    
    August 31,2005
    
    
    2004AssetsCash and cash equivalents
    
    $
    15,797
    
    
    $
    15,203Auction rate securities
    
    
    7,500
    
    
    
    12,525Trade receivables, net
    
    
    3,036
    
    
    
    2,431Other receivables
    
    
    577
    
    
    
    553Other current assets
    
    
    3,321
    
    
    
    3,479Restricted investments
    
    
    258
    
    
    
    283Total current assets
    
    
    30,489
    
    
    
    34,474Restricted investments
    
    
    9,870
    
    
    
    10,609Property plant and equipment, net
    
    
    18,702
    
    
    
    24,508Intangibles, net
    
    
    8,706
    
    
    
    12,077Other assets
    
    
    3,244
    
    
    
    3,244Total assets
    
    $
    71,011
    
    
    $
    84,912Liabilities and shareholders equityAccounts payable
    
    $
    1,181
    
    
    $
    2,517Accrued expenses
    
    
    11,362
    
    
    
    12,105Accrued restructuring charges
    
    
    3,244
    
    
    
    4,393Current portion of long-term debt and capital lease obligations
    
    
    1,154
    
    
    
    2,271Deferred revenue
    
    
    7,111
    
    
    
    7,777Total current liabilities
    
    
    24,052
    
    
    
    29,063Long-term debt and capital lease obligations
    
    
    3,016
    
    
    
    3,473Deferred revenue, long-term
    
    
    235
    
    
    
    268Other liabilities
    
    
    1,953
    
    
    
    3,209Total liabilities
    
    
    29,256
    
    
    
    36,013Commitments and contingencies
    
    
    
    
    
    
    Shareholders equityCommon stock, $.01 par value, authorized 21 million shares,
issued and outstanding 16.1 and 16.1 million shares,
respectively
    
    
    161
    
    
    
    161Additional capital
    
    
    321,557
    
    
    
    321,091Warrants
    
    
    4,141
    
    
    
    4,603Deferred compensation
    
    
    
    
    
    
    (320
    )Note receivable from shareholder
    
    
    (735
    )
    
    
    (735
    )Accumulated deficit
    
    
    (283,369
    )
    
    
    (275,901
    )Total shareholders equity
    
    
    41,755
    
    
    
    48,899Total liabilities and shareholders equity
    
    $
    71,011
    
    
    $
    84,912
 The accompanying notes are an integral part of these consolidated financial statements.




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INTERLAND, INC. 
 Consolidated Statements of Cash Flows 
 For the six months endedFebruary 28,
    
    
    February 29,2005
    
    
    2004CASH FLOWS FROM OPERATING ACTIVITIESNet loss
    
    $
    (7,468
    )
    
    $
    (18,652
    )Adjustments to reconcile net loss to net cash used in operating
activities from continuing operations:(Gain) Loss from discontinued operations
    
    
    (513
    )
    
    
    1,321Depreciation and amortization
    
    
    11,184
    
    
    
    16,422Bad debt expense
    
    
    905
    
    
    
    2,066(Gain) Loss on sale of assets
    
    
    59
    
    
    
    (71
    )Other non-cash adjustments
    
    
    320
    
    
    
    548Changes in operating assets and liabilities net of effect of acquisitions:Receivables, net
    
    
    (1,534
    )
    
    
    (1,231
    )Other current and non current assets
    
    
    158
    
    
    
    540Accounts payable, accrued expenses, other liabilities and deferred revenue
    
    
    (4,365
    )
    
    
    (7,879
    )Cash used in operating activities of continuing operations
    
    
    (1,254
    )
    
    
    (6,936
    )CASH FLOWS FROM INVESTING ACTIVITIESExpenditures for property, plant, and equipment
    
    
    (2,066
    )
    
    
    (5,545
    )Purchase of auction rate securities
    
    
    
    
    
    
    (1.500
    )Proceeds from auction rate securities
    
    
    5,025
    
    
    
    10,500Reductions in restricted investments
    
    
    764
    
    
    
    7,201Acquisitions, net of cash acquired
    
    
    
    
    
    
    120Cash provided by investing activities of continuing operations
    
    
    3,723
    
    
    
    10,776CASH FLOWS FROM FINANCING ACTIVITIESRepayments of debt and capital lease obligations
    
    
    (1,574
    )
    
    
    (6,112
    )Proceeds from issuance of common stock
    
    
    4
    
    
    
    Cash used in financing activities of continuing operations
    
    
    (1,570
    )
    
    
    (6,112
    )Net cash provided by (used in) continuing operations
    
    
    899
    
    
    
    (2,272
    )Net cash used in discontinued operations
    
    
    (305
    )
    
    
    (1,359
    )Net increase (decrease) in cash and cash equivalents
    
    
    594
    
    
    
    (3,631
    )Cash and cash equivalents at beginning of period
    
    
    15,203
    
    
    
    25,530Cash and cash equivalents at end of period
    
    $
    15,797
    
    
    $
    21,899
 The accompanying notes are an integral part of these consolidated financial statements.




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Interland, Inc. 
 Notes To Consolidated Financial Statements  1.
    GeneralBusiness Interland, Inc., together with its subsidiaries (collectively the Company), is a
leader in efficiently packaging, distributing, and supporting business-class, online marketing
solutions to small and medium business (SME) owners, both directly and through partners,
enabling those businesses to gain new relationships and better support communication with their
existing customers locally and around the world. Interland operates as a single reportable
segment and offers a broad range of products and services, including shared and dedicated
hosting services, e-commerce, application hosting, website development, marketing, and
optimization tools.History of operating losses The Companys Web hosting business has historically incurred net
losses and losses from operations. The Companys future operation is dependent upon its ability
to achieve and sustain positive cash flow prior to the depletion of cash resources. The Company
has reduced its level of cash requirements through decreases in capital purchases, reducing
operating expenses, and by improving the ratio of new customer accounts to canceling accounts.
Additionally, the Company will have lower future cash outlays for payments associated with prior
integration and discontinued operation liabilities and reduced debt payments because it settled
a number of capital lease obligations during the prior fiscal year. There can be no assurance
that Interlands continuing efforts to stabilize or increase its revenue will be successful or
that the Company will be able to continue as a going concern. If the Company is unable to
successfully execute its business plan, it may require additional capital, which may not be
available on suitable terms. Nonetheless, management believes it has adequate cash and liquid
resources to fund operations and planned capital expenditures through at least the next 12
months.2.
    Significant Accounting PoliciesInterim Unaudited Financial Information The accompanying unaudited consolidated financial
statements for the three and six-month periods ended February 28, 2005 and February 29, 2004,
have been prepared in accordance with accounting principles generally accepted in the United
States of America for interim financial information. In managements opinion, these statements
include all adjustments necessary for a fair statement of the results of the interim periods
shown. All adjustments are of a normal recurring nature unless otherwise disclosed. Operating
results for the three and six-month periods ended February 28, 2005 are not necessarily
indicative of the results that may be expected for the full fiscal year.Basis of Presentation This report on Form 10-Q (10-Q) for the second quarter ended February
28, 2005 should be read in conjunction with the Companys Form 10-K (10-K) for the fiscal year
ended August 31, 2004. The financial statements include the accounts of Interland, Inc. and its
wholly owned subsidiaries. All significant intercompany balances and transactions have been
eliminated.Stock-based employee compensation The Company accounts for stock-based compensation issued to
employees using the intrinsic value method as prescribed by Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees and has adopted the disclosure
requirements of SFAS No. 123 and SFAS 148.In December 2004, the Financial Accounting Standards Board (FASB) issued its final standard on
accounting for share-based payments, FASB Statement No. 123R that requires companies to expense
the value of employee stock options and similar awards. It requires a public entity to measure
the cost of employee services received in exchange for an award of equity instruments based on
the grant-date, fair value of the award. That cost will be recognized over the period during
which an employee is required to provide service in exchange for the award. FAS 123R applies to
awards that are granted, modified or settled in interim or fiscal periods beginning after the
effective date. The adoption of this standard is required for public entities effective as of
the beginning of the interim or annual reporting period that starts after June 15, 2005.The company has not yet adopted nor does it expect to early adopt the new standard. The impact
that may result from the adoption of FAS 123R on the companys results of operations, financial
position or its cash flows is not yet known and the Company has not yet selected the valuation
method to be used. However, had we adopted SFAS 123R in prior periods, the impact of that
standard would have approximated the impact of SFAS 123 as described in the disclosure of pro
forma net loss and loss per share in Note 2 to the consolidated financial statements. We expect
our earnings and earnings per share will be adversely affected upon adoption of SFAS No. 123R.The following table illustrates the effect on net loss and loss per share if the Company had
elected to adopt the optional recognition provisions of SFAS No. 123, which uses the fair value
based method for stock-based compensation, and amortized the fair value of the options to
compensation expense on a straight-line basis over the vesting period of the options.




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Interland, Inc. Notes To Consolidated Financial Statements Three-month period ended
    
    
    Six-month period endedFebruary 28,
    
    
    February 29,
    
    
    February 28,
    
    
    February 29,2005
    
    
    2004
    
    
    2005
    
    
    2004in thousands, except per share numbersNet loss as reported
    
    $
    (4,272
    )
    
    $
    (10,100
    )
    
    $
    (7,468
    )
    
    $
    (18,652
    )Add: Stock-based employee compensation expense included in
reported net income, net of related tax effects
    
    
    162
    
    
    
    174
    
    
    
    320
    
    
    
    347Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards, net of
tax effects
    
    
    (296
    )
    
    
    (1,147
    )
    
    
    (712
    )
    
    
    (1,723
    )Proforma net loss
    
    
    (4,406
    )
    
    $
    (11,073
    )
    
    $
    (7,860
    )
    
    $
    (20,028
    )Loss per share:Basic and diluted  as reported
    
    $
    (0.27
    )
    
    $
    (0.62
    )
    
    $
    (0.47
    )
    
    $
    (1.15
    )Basic and diluted  pro forma
    
    $
    (0.27
    )
    
    $
    (0.68
    )
    
    $
    (0.49
    )
    
    $
    (1.24
    )Weighted average shares outstanding basic and diluted
    
    
    16,026
    
    
    
    16,213
    
    
    
    16,021
    
    
    
    16,188
  3.  Restructuring And Facility Exit Costs2001 PlanDuring the fourth quarter of 2001, the Company approved and implemented a restructuring program
in connection with its acquisition of Interland-Georgia (the 2001 Plan). This restructuring
plan provided for the consolidation of the Companys operations and elimination of duplicative
facilities obtained as a result of previous business acquisitions and has expected payments
through December 2009. During the six months ended February 28, 2005, cash payments of $1.0
million were made related to the monthly lease obligations for lease abandonments leaving an
outstanding liability of $2.7 million as of February 28, 2005. The liability balances and
annual activity from inception through August 31, 2004 are disclosed in the 2004 10-K.2003 PlanDuring the second quarter of 2003, the Company approved and initiated a program to exit certain
facilities and consolidate those operations into other existing facilities (the 2003 Plan).
This restructuring plan was part of managements continued plan to streamline the Companys
operations and to reduce long-term operating costs. In accordance with SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal Activities, costs associated with these
activities have been recognized and measured at their fair value in the period in which the
liabilities are incurred. The $0.5 million balance at February 28, 2005 represents the remaining
bandwidth termination liabilities, which the Company expects to have final resolution during
fiscal year 2005. The liability balances and annual activity from inception through August 31,
2004 are disclosed in the 2004 10-K.2004 PlanIn March 2004, the Company decided to change its approach to distributing its mainstream market
hosting solutions from reliance upon a direct field sales force to an indirect channel approach
(the 2004 Plan). Due to this decision, the Company implemented a restructuring program to
reduce its cost structure. During the six months ended February 28, 2005, cash payments of $0.2
million were made related to the final severance payout and monthly lease obligations. The
remaining liability of $0.1 million related to lease abandonments is to be paid out by April
2005. The liability balances and annual activity from inception through August 31, 2004 are
disclosed in the 2004 10-K.4.
    Purchase Business Combination LiabilitiesIn connection with the acquisition of Interland-Georgia in 2001, INNERHOST in 2002, and Trellix
in 2003, the Company accrued certain liabilities representing estimated costs of exiting certain
facilities, termination of bandwidth contracts and involuntary termination of employees in
accordance with EITF 95-3, Recognition of Liabilities in Connection with a Purchase




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Interland, Inc. Notes To Consolidated Financial Statements  Business Combination. During the six month period ended February 28, 2005, the Company continued to
make its monthly lease payment and collect from its sub tenants for its lease abandonment
obligations according to the contractual agreements ending in 2009.The liability balances and annual activity from inception through August 31, 2004 are disclosed
in the 2004 10-K. The following table shows the changes in the accrual from August 31, 2004
through February 28, 2005: Lease(in thousands)
    

       abandonmentsBalance at August 31, 2004
    
    $
    740Net Cash Paid
    
    
    (89
    )Balance at February 28, 2005
    
    $
    651
  5.
    Investment SecuritiesThe following table summarizes, by major security type, the value of the Companys investments.
The carrying value of these investments approximates fair value. As ofFebruary 28,
    
    
    August 31,2005
    
    
    2004(In thousands)Available-for-sale securities, at fair value:Commercial paper
    
    $
    11,078
    
    
    
    13,521State and local government
    
    
    
    
    
    
    3,000Certificates of deposit
    
    
    1,138
    
    
    
    1,113Held-to-maturity securities, at
amortized cost:Auction rate securities
    
    
    7,500
    
    
    
    12,525Total securities
    
    
    19,716
    
    
    
    30,159Less: cash equivalents
    
    
    (3,138
    )
    
    
    (8,113
    )Less: restricted cash
    
    
    (9,078
    )
    
    
    (9,521
    )Auction rate securities
    
    $
    7,500
    
    
    $
    12,525
  Cash and cash equivalents consist of cash and investments in certificates of deposit, commercial paper and
other highly liquid securities with original maturities less than
90 days. We had historically
classified auction rate securities as cash and cash equivalents if the period between the interest
rate resets was 90 days or less, which was based on our ability to either liquidate our holding
or roll our investments over to the next reset period. Based on our re-evaluation of the
maturity dates associated with the underlying bonds, we have reclassified our auction rate
securities, previously classified as cash and cash equivalents, as
auction rate securities for
each of the periods presented in the accompanying consolidated balance sheets. Auction rate
securities are variable rate bonds tied to short term interest rates with maturities on the face
of the securities in excess of 90 days. Auction rate securities have interest rate resets
through a modified Dutch auction, at predetermined short term intervals, usually every 7, 28 or
35 days. They generally trade at par and are callable at par on any interest payment date at the
option of the issuer. Interest paid during a given period is based upon the interest rate
determined through the auction process. Although these securities are issued and rated as long
term bonds, they are priced and traded as short term instruments because of the liquidity
provided through the interest rate reset. All auction rate securities are available for sale and
are reported at fair




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Interland, Inc. Notes To Consolidated Financial Statements  value. A total of $6.0 million and $10.0 million have been reclassified
from cash and cash equivalents to short-term investments as of February 28, 2005 and August 31,
2004, respectively. These auction rate securities investments remain readily available to the
Company and are considered short-term and liquid in accordance with the reset period.6.
    Other LiabilitiesIn December 2004, the Company received a revised tax assessment regarding a sales and use tax
audit from the state of Virginia relating to the discontinued PC Systems business segment. This
revised assessment was substantially lower than the prior assessment and resulted in a reduction to a previously recorded sales tax reserve for the
quarter ended November 30, 2004. The revised sales tax assessment of $0.2 million was paid
during the quarter ended February 28, 2005.7.
    Discontinued OperationsIn fiscal 2001 the Company discontinued the operations of its PC Systems business segment, which
was accounted for as discontinued operations in accordance with Accounting Principles Board
Opinion (APB) No. 30, Reporting the Results of Operations  Reporting the Effects of Disposal
of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions. During the first six months of 2005, the Company recognized a gain of $0.5
million from discontinued operations. This gain consisted of a reduction to a previously
recorded sales tax reserve by $0.8 million, offset by $0.3 million of required legal fees in
defense and settlement of Micron PC legal matters. The Company has sales and use tax
assessments and audit reserves of $0.1 million, $0.7 million in contingent liabilities, $0.1
million in legal fees and $0.3 million for other liabilities related to the disposal of
discontinued operations that are included in accrued liabilities on the Companys consolidated
balance sheet as of February 28, 2005.8.
    ContingenciesInterland is also defending a case entitled Novell, Inc. v. Micron Electronics, Inc. filed in
August 1999 in state court in Utah County, Utah. Novell claims that it was underpaid for
royalties on sales of several versions of its NetWare software purportedly distributed by
Interlands predecessor, Micron Electronics, between 1996 and 1998. In addition, Novell also
believes it is entitled additional royalties for sales of the software purportedly distributed
by NetFrame between 1993 and 1997. Micron Electronics acquired NetFrame in 1997. Novell is
seeking an accounting of royalties and damages. Interland believes it has meritorious defenses
to Novells claims. The litigation is still in the discovery phase.In February 2004, the Company, through its Hostcentric subsidiary, also initiated a lawsuit in
United States District Court for Southern District of New York against the landlord for the same
Farmingdale, New York facility. The Company believes that it and the landlord reached an
agreement in principle to settle the litigation and has petitioned the court to enforce the
agreement. Interland believes that no material adverse effect on Interland will occur as a
result of this litigation.In February of 2003, the Company filed a lawsuit in Cobb County, Georgia against Mr. Gabriel
Murphy, one of the former principals of Interlands subsidiary, CommuniTech.Net, Inc.
(Communitech), which was acquired by Interland in February 2002. The Companys lawsuit claims,
among other things, that Mr. Murphy breached certain covenants under his employment agreement
and also demands payment from Mr. Murphys two promissory notes (one of which was non-recourse
while the other was recourse). In March 2004, Interland retired the 273,526 shares of stock
held as collateral and wrote off the $2,000,000 non-recourse promissory note, which had been
carried as Stockholders Equity. The other $735,000 full recourse promissory note remains
outstanding and continues to be a subject of the Cobb County litigation noted herein. Mr.
Murphy has asserted various counterclaims in response.In February 2003, Mr. Heitman, also a former principal of Interlands subsidiary Communitech,
and Mr. Murphy filed a lawsuit against Interland, its Chief Executive Officer, Mr. Joel Kocher,
and Communitech, in Jackson County, Missouri claiming, among other things, that Interland acted
unreasonably in failing to have the S-3 registration statement declared effective by the SEC on
a timely basis and claiming that Interland and/or Mr. Kocher made inaccurate disclosures in
connection with Interlands acquisition of Communitech. The complaint sought compensatory and
punitive damages in an unspecified amount. Interland believes that these claims are without
merit and will not have a material adverse effect on Interland and is vigorously defending the
claims. The Interland parties have filed motions to dismiss all of the claims against them and
those motions are pending.Interland is defending another case in Jackson County, Missouri arising out of the shutdown of
five unregistered servers at the Communitech data center in February 2003. An entity called
Bent Axis and its principle owner, Jason Park, have filed suit against the Company and its
General Counsel, Jonathan Wilson, alleging a variety of contract and tort claims. In its first
complaint, Bent Axis asserted that it owned the five servers in question. It later amended its
pleading to assert a different theory: that it was using the servers by permission of certain
Interland personnel. Bent Axis claims that it was damaged when the Company disconnected the
servers in question, although Bent Axis has produced no documentary evidence that it had ever
generated a profit or that it had any right to use the servers in question. The Company is
vigorously defending the suit and believes that it will not have a material adverse effect on
Interland.In February 2004, the Company initiated a lawsuit in the United States District Court for the
Northern District of Georgia against the representatives of the former shareholders of
Hostcentric (the Hostcentric Shareholders), seeking a declaratory judgment that it will be
entitled to reimbursement from the escrow fund established as part of the Hostcentric
acquisition for any amounts over $180,000 that it may be required to pay to the landlord for a
leased facility in Farmingdale, New York, in accordance with the acquisition agreement between
the Company and Hostcentric and its shareholders. The representatives of the Hostcentric
Shareholders have denied Interlands claims and have attempted to assert various counterclaims.
The Company, has in turn, brought additional claims based on facts learned in discovery.
Correspondence between the parties has also discussed the possibility of other claims, but these
claims have not yet been asserted in litigation. Interland believes its claims in this case
are




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Interland, Inc. Notes To Consolidated Financial Statements  meritorious, that the counterclaims of the former Hostcentric shareholders are without
merit, plans to continue to contest the matter vigorously and believes that no material adverse
effect on Interland will occur as a result of this litigation.Interland is the defendant in a case involving the Telephone Consumer Protection Act (TCPA) in
state court in Allegheny County, Pennsylvania. A competing web hosting company, PairNetworks,
filed this case in December 2001 as a putative class action, claiming that Interlands
distribution of a facsimile on November 15, 2001 to market domain name registration services
violated the TCPA. Several years later, two additional plaintiffs joined in the action. The
plaintiffs have conceded that all of the putative class members were customers of Interland. Federal Communications Commission
regulations in effect at the time provided that the distribution of facsimiles to persons with
whom the sender had an established business relationship did not amount to a violation of the
TCPA. Interland has asked the court to deny class certification and a ruling on that motion is
pending as well as a motion for summary judgment on the named plaintiffs claims. If the
court denies class certification, Interlands damages, if it were liable, cannot exceed $1,500
for each of the three named plaintiffs. Interland believes that the plaintiffs claims are
without merit, plans to continue to contest the matter vigorously and believes that no material
adverse effect on Interland will occur as a result of this litigation.The Company is defending a case in federal court in the Southern District of Florida arising out
of the management of a co-located server by its predecessor company, Worldwide Internet
Publishing Corporation. The suit alleges that the Company is responsible for the loss of
Plaintiffs internet search engine that occurred after the resignation of the officer managing
the server, Mark Ismach, in October 1999. Interland believes that it has meritorious defenses
to the claims such as provisions in the contract that specifically exclude the damages sought by
Plaintiff. Interland believes the plaintiffs claims are without merit, plans to continue to
contest the matter vigorously, and believes that no material adverse effect on Interland will
occur as a result of this litigation.On January 23, 2004, Vincent Salazar, an individual, sued Interland and its predecessor HostPro
claiming that he was entitled to money as a result of his alleged involvement in brokering
Interlands acquisition of accounts from AT&T in January 2002. The case is pending in federal
court in Los Angeles. The Plaintiff asserted fraud and breach of contract claims (the fraud
claim was dismissed by the court) and has alleged that he is due 20% of the revenue that
Interland has received from the acquired accounts. Interland believes it has meritorious
defenses, including that HostPros contract with Mr. Salazar specifically excludes compensation
for the very sort of transaction on which he is seeking to be paid a fee. Interland believes
the plaintiffs claims are without merit, plans to continue to contest the matter vigorously and
believes that no material adverse effect on Interland will occur as a result of this litigation.In May 2004, Interland was served with a suit filed by Net Global Marketing against Interland
and its predecessor, Dialtone, asserting claims for lost data. Interland had cancelled Net
Globals web hosting accounts in October 2002 and again in January 2003 as a result of
complaints that the servers were being used to send spam and Interland has asserted
counterclaims arising from these incidents. Interland filed a motion to dismiss in favor of
arbitration that was denied, and Interland has appealed that decision to the Ninth Circuit Court
of Appeals. Interland believes that, even if the litigation proceeds, it has adequate defenses
including provisions in the contract with the plaintiff that shield Dialtone from damages for
erasure and loss of data and generally prohibit recovery of the kind of damages sought by
plaintiff. Interland believes that the plaintiffs claims are without merit, plans to continue
to contest the matter vigorously and believes that no material adverse effect on Interland will
occur as a result of this litigation.Interland is defending an arbitration proceeding pending in Atlanta, Georgia before the American
Arbitration Association filed by SmartText Corporation. In August 2003, SmartText filed an
action in federal court in Kansas. The case was dismissed in favor of arbitration in February
2004 after a jury trial. SmartText Corp. v. Interland, Inc., 296 F.Supp.2d 1257, 1262-63 (D.Kan.
2003). SmartText is claiming damages suffered as a result of Interlands migration of
its website around January 2002 including loss of revenue, costs for rebuilding the website and
the value of lost software located on the site. Interlands contract with the customer contains
a general limitation of liability and waivers of the specific damages allegedly suffered by
SmartText. Interland believes that the plaintiffs claims are without merit, plans to continue
to contest the matter vigorously and believes that no material adverse effect on Interland will
occur as a result of this litigation.




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Interland, Inc. Notes To Consolidated Financial Statements  Periodically, the Company is made aware that technology it used in its discontinued operations
may have infringed on intellectual property rights held by others. The Company has evaluated all
such claims and, if necessary and appropriate, sought to obtain licenses for the use of such
technology. If the Company or its suppliers were unable to obtain licenses necessary to use
intellectual property in its discontinued operations products or processes, it may be forced to
defend legal actions taken against it relating to allegedly protected technology. The Company
evaluates all such claims and has accrued a liability and charged discontinued operations for
the estimated costs of settlement or adjudication of claims for alleged infringement as of the
respective dates of the balance sheets included in this report.The Company is also a defendant in a number of other lawsuits seeking lesser amounts, and which
the Company regards as unlikely to result in any material payment. The outcome of litigation
may not be assured, and despite managements views of the merits of any litigation, or the
reasonableness of its estimates and reserves, the Companys cash balances could nonetheless be
materially affected by an adverse judgment. In accordance with SFAS No. 5 Accounting for
Contingencies, the Company believes it has adequately reserved for the contingencies arising from the above legal matters
where an outcome was deemed to be probable and the loss amount could be reasonably estimated. As
such, the Company does not believe that the anticipated outcome of the aforementioned
proceedings will have a materially adverse impact on its results of operations, its financial
condition or its cash flows.




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Interland, Inc. 
 Item 2. Managements Discussion And Analysis Of Financial Condition And Results Of
Operations Statements contained in this Form 10-Q that are not purely historical are forward-looking
statements and are being provided in reliance upon the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Words such as anticipates, expects, intends,
plans, believes, seeks, estimates, and similar expressions identify forward-looking
statements. These forward-looking statements include but are not limited to statements regarding
Interlands expectations of its future liquidity needs, its expectations regarding its future
operating results including its planned increase in its revenue levels and the actions the Company
expects to take in order to maintain its existing customers and expand its operations and customer
base. All forward-looking statements are made as of the date hereof and are based on current
management expectations and information available to it as of such date. The Company assumes no
obligation to update any forward-looking statement. It is important to note that actual results
could differ materially from historical results or those contemplated in the forward-looking
statements. Forward-looking statements involve a number of risks and uncertainties, and include
risks associated with our target markets and risks pertaining to our ability to successfully
integrate the operations and personnel of prior acquisitions. Factors that could cause actual
results to differ materially from expected results are identified in Risk Factors below, and in
the Companys Form 10-K for the year ended August 31, 2004 and in the Companys other filings with
the Securities and Exchange Commission. All quarterly references are to the Companys fiscal
periods ended February 28, 2005, or February 29, 2004, unless otherwise indicated. All annual
references are also on a fiscal August 31st year-end basis, unless otherwise
indicated. All tabular dollar amounts, except earnings per share, are stated in thousands. Overview Interland, Inc., the (Company), is a leader in making the power of the Internet available to small-
and medium-sized enterprises (SMEs). In addition to providing traditional web-hosting and
electronic commerce services to those who desire mere presence on the World Wide Web, Interland
offers products and services designed to permit a SME to utilize a website as an alternative
communication channel with its clients and potential clients. The Companys offerings make it
possible and efficient for SMEs to find leads, make sales, and to service their clients online. The Company has acquired and developed proprietary software for the efficient integration,
packaging and support of new technologies and services into its basic hosting products. These tools
can be configured to enable only modestly-trained SME business personnel to design a website with
great functionality in a fraction of the time and at a fraction of the cost charged by website
development firms. The tools can also be configured to provide additional functionality designed to
be used by professional web designers who can thereby gain high productivity, enabling the Company
to provide professional-quality websites at modest cost. The Companys growing experience in
designing websites for a large number of types of businesses further contributes to efficiency.
Using the website development tools as a base, the Company is continuing to develop a broad range
of products and services designed to help mainstream businesses attract and serve customers through
websites supplied by Interland designers using its proprietary design software. Interland
periodically assesses the value of both existing and contemplated service offerings to customers
through extensive marketing research directed to its existing customers, with special focus on
customers who appear to be successful in using online resources. The Company offers to its customers website marketing, design and management, as well as management
of hosted application services through direct and partnership channels to both its shared and
dedicated product lines. The shared product lines provide services to customers whose needs are
compatible with being hosted on a server that hosts hundreds of other similar customers; the
dedicated product lines serve customers who require a server or servers exclusively devoted to
their needs. The Company assembles, bundles and tailors its products to meet the requirements of the
distribution partners targeted markets, taking into account the respective mechanisms of
distribution and branding. Interland provides applications on Linux and Microsoft Windows
platforms, which may be used while the customer is an Interland hosting customer. Among these
services are website marketing services, website creation and management services, electronic
commerce services, email services, and hosting services. In the dedicated product lines Interland
provides applications on dedicated servers, as well as network and hardware reliability and
security products, marketing services, and bundles supporting outsourcing of specific web-based
applications. The lack of technical sophistication of many SMEs, coupled with the relatively high
cost of maintaining dedicated servers in-house makes Interlands dedicated offerings attractive to
this market. Larger enterprises use Interlands dedicated services to develop and host specific
activities, often those that are specialized or developmental in nature. A smaller portion of
Interlands dedicated business serves larger enterprises that require managed services provided
through multiple servers. Distribution partners enable the Company to acquire new customers at a lower cost relative to
revenue than would be possible through direct marketing and sales. Interlands distribution
partners now include telecommunications companies, Yellow Pages publishers, credit card companies,
as well as local resellers, which also often provide other technology services to their clients.
Interland intends to expand and grow its relationships with these partners as well as work with new
partnerships relationships in the future.




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DISCONTINUED OPERATIONS PC Systems In fiscal 2001 the Company discontinued the operations of its PC Systems business segment, which
was accounted for as discontinued operations in accordance with Accounting Principles Board Opinion
(APB) No. 30, Reporting the Results of Operations  Reporting the Effects of Disposal of a Segment
of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.
During the first six months of 2005, the Company recognized a gain of $0.5 million from
discontinued operations. This gain consisted of a reduction to a previously recorded sales tax
reserve by $0.8 million, offset by $0.3 million of required legal fees in defense and settlement of
Micron PC legal matters. The Company has sales and use tax assessments and audit reserves of $0.1
million, $0.7 million in contingent liabilities, $0.1 million in legal fees and $0.3 million for
other liabilities related to the disposal of discontinued operations that are included in accrued
liabilities on the Companys consolidated balance sheet as of February 28, 2005. RESULTS OF CONTINUING OPERATIONS The Companys consolidated financial information presents the net effect of discontinued operations
separate from the results of the Companys continuing operations. Comparison of the Three and Six Months Ended February 28, 2005 and February 29, 2004 The loss from continuing operations decreased $5.2 million, or 55.3% and $9.4 million, or 53.9% for
the three and six months ended February 28, 2005, respectively, when compared to the same periods
of the prior fiscal year. The basic and diluted loss per share decreased $0.32 per share, or 55.2%,
and $0.57 per share or 53.3% for the quarter and for the six months ended February 28, 2005,
respectively, when compared to the same periods of the prior fiscal year. Revenues Total revenues decreased $3.4 million, or 13.1%, and $7.0 million, or 13.3%, respectively, for the
three and six months ended February 28, 2005 when compared to the same periods of the prior fiscal
year. For the three months ended
    
    
    For the six months endedFebruary 28,
    
    
    February 29,
    
    
    February 28,
    
    
    February 29,2005
    
    
    2004
    
    
    2005
    
    
    2004in thousandsHosting revenue
    
    $
    21,456
    
    
    $
    24,718
    
    
    $
    43,366
    
    
    $
    50,163Other revenue
    
    
    1,166
    
    
    
    1,311
    
    
    
    2,317
    
    
    
    2,553Total revenue
    
    $
    22,622
    
    
    $
    26,029
    
    
    $
    45,683
    
    
    $
    52,716
 Hosting revenues decreased
$3.3 million, or 13.2%,
and $6.8 million, or 13.5% for the three and six months ended
February 28, 2005, respectively, when compared to the same
periods of the prior fiscal year. Hosting revenues are comprised of
shared, dedicated, mainstream market, application hosting services
and domain name registrations. The decrease in hosting revenues is
primarily attributable to account cancellations, net of new sales.
These cancellations may occur as a result of: a) customer action; b)
termination by the Company for non-payment; or c) termination by the
Company as a result of a decision to no longer provide a particular service. Other revenues decreased
$0.1 million, or 11.1%, and $0.2 million or 9.2%, for the
three and six months ended February 28, 2005, respectively, when
compared to the same period of the prior fiscal year. Other revenues
are primarily comprised of consulting services, bandwidth transfer
overage billings, Internet connectivity fees and co-location
services. The decrease in other revenues is primarily due to the
Company not actively pursuing the sale of its non-hosting services
and products. As of February 28, 2005, the Company had approximately 172,000 paid shared hosting customer accounts and managed approximately 8,900 dedicated servers, many of which host multiple web sites, compared to approximately 188,000 paid shared hosting customer accounts and 9,900 dedicated servers as of February 29, 2004. The decrease in shared hosting customer accounts is primarily due to customer churn during the year. As customers leave the Company these servers are removed from the data center and taken out of operation until they can be re-utilized by a new customer. The number of dedicated servers decreased both through attrition and through the sale of 23 co-location accounts, which were sold to a third party in connection with the Companys closure of its Boise, Idaho facility. The Companys revenues are highly correlated with the net change in the total of the monthly recurring charges associated with all




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customer accounts. The term Monthly Recurring
Charges or MRC, does not include one-time or variable charges customers may incur, nor is it the same as the actual amount of revenue recognized because, among other things, MRC ignores deferred revenue, and instead uses the charge that applies to a full month. (For revenue recognition purposes a customer who initiates service during the month contributes to revenue the same percentage of the nominal monthly charge as the percentage of the month remaining at inception; a customer who terminates service during the month contributes to revenue the same percentage of the nominal monthly charge as the percentage of the month that elapsed prior to termination. An initiating customers entire nominal monthly charge is included in MRC as of the end of the month, but no portion of a terminating customers nominal monthly charge is included in MRC as of the end the month during which termination occurs.) MRC, therefore, is not a measure of historical revenues but rather a metric for valuing the revenue potential of the entire customer base as of the end of a period. The Company believes that MRC is useful as a reflection of changes in the base of revenue-generating customers and, consequently, as a predictor of the direction of revenue in the future. It is unlikely that Interlands future revenues will increase unless Net MRC Change is positive, and the Company does not have a recent history of positive Net MRC Change aside from mergers and acquisitions. Management believes that Net MRC Change is a key metric for assessing the Companys progress toward revenue growth. During the second quarter of fiscal 2005 the MRC of the Companys Shared product lines declined from $4,137,000 at November 30, 2004 to $4,085,000 at February 28, 2005, or 1.3%. MRC Churn (MRC of terminating customers as a percentage of beginning MRC) averaged 2.6% per month during the quarter ended February 28, 2005 compared to an average of 2.5% during the quarter ended November 30, 2004, a rate which the Company regards as consistent with industry averages. Sales produced average monthly New Shared MRC of $93,000 during the quarter ended February 28, 2005, an improvement of 41% over the first fiscal quarters average monthly sales of $66,000. Average negative Net MRC Change during the second quarter was $18,000 per month, compared to $48,000 per month in the first quarter and $68,000 in the fourth quarter of fiscal 2004. The Company believes that it is unlikely that Shared MRC Churn can be reduced below 2.0%, but believes that its current strategy of increasing new sales through indirect distribution of enhanced products and services has the potential to generate enough new business to exceed the amount of MRC Churn and result in positive Net MRC Change and revenue growth. During the second quarter of fiscal 2005 the MRC of the Companys Dedicated product lines declined from $2,927,000 at November 30, 2004 to $2,876,000 at February 28, 2005, or 1.7%. MRC Churn averaged 4.5% during the quarter ended February 28, 2005 compared to an average of 3.7% during the quarter ended November 30, 2004. New Dedicated sales averaged $113,000 per month for the quarter ended February 28, 2005, compared with $101,000 of new sales during the quarter ended November 30, 2004, an improvement of 12% quarter-over-quarter. Monthly negative Net MRC Change for the quarter was $17,000 compared to $29,000 per month during the previous quarter and $47,000 during the fourth quarter of fiscal 2004. The Dedicated product lines revenue has been affected, and is likely to continue to be affected, by a general reduction in pricing in the industry. MRC Churn in the dedicated line also is driven by rapid changes in server technology, creating in the customer a desire to seek the latest technology at the lowest price in a highly competitive market. Due to recent increases in MRC Churn and price competition, the Company is re-evaluating the profitability of its Dedicated products and seeking alternatives to maximize the Companys returns in this market. The Company is now offering many of the products and services it has developed primarily for the Shared market to Dedicated customers. Due to the capital cost required to service a new Dedicated customer, the relationship with dedicated customers must be profitable from an operating standpoint and it must remain in place long enough for the Company to recoup its investment and provide a satisfactory return on assets employed. Overall, the average monthly negative Net MRC change improved to $34,000 during the second quarter from $77,000 during the previous fiscal quarter and from $115,000 during the fourth quarter of fiscal 2004. This critical metric has improved by 56% during the second quarter and by 70% over the first half of fiscal 2005. To add perspective, were the Companys monthly average Net MRC change to continue to improve by the same $43,000 by which it improved in the second quarter, the additional revenue during the ensuing twelve months would be over $3.3 million. This same principle of compounding impact would have a similar negative effect if Net MRC change were to deteriorate. (For additional explanation of this principle see Risk Factors Ours is a recurring-revenue subscriber business and as such the effects of a net loss of monthly recurring revenue are magnified). OPERATING COSTS AND EXPENSES Network Operating Costs Network operating costs were $5.3 million compared to $7.1 million for the three months ended February 28, 2005 and February 29, 2004, respectively. This decrease of $1.8 million, or 24.9%, is attributable primarily to the data center consolidation, which was a critical part of the Companys restructuring and integration initiative in fiscal 2003. The impact of this initiative had a $0.6 million reduction in bandwidth connectivity costs and a $0.8 million reduction in labor costs. For the six months ended February 28, 2005 network operating expenses were $11.0 compared to $14.2 million for the six months ended February 29, 2004. This decrease of $3.2 million, or 22.4%, is primarily attributable to the same data center consolidation efficiencies noted in the quarter comparison above with reductions in bandwidth costs of $1.1 million and salaries and benefits costs of $1.4 million.




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Sales and Marketing Sales and marketing expenses were $4.4 million compared to $6.5 million for the three months ended February 28, 2005 and February 29, 2004, respectively. The Companys sales and marketing expenses as a percentage of revenues were 19.4% for the quarter as compared to 25.1% in the same period of the prior fiscal year. This decrease of $2.2 million, or 33.0%, is primarily due to the elimination of additional marketing expenditures related to the direct mainstream market initiative when the company publicly announced it would substantially reduce its investment in direct marketing and sales initiatives in March 2004. For the six months ended February 28, 2005 sales and marketing expenses were $8.3 million compared to $11.7 million for the six months ended February 29, 2004. As a percentage of revenue, sales and marketing expenses was 18.3% as compared to 22.3% in the same period of the prior fiscal year. This decrease of $3.4 million, or 28.9%, is primarily related to the decrease in salaries and benefits of $1.9 million, facilities overhead of $0.2 million and $0.8 million decrease in advertising and public relations associated with the overall reduction of mainstream marketing personnel. Technical Support Technical support expenses were $3.7 million compared to $4.6 million for the three months ended February 28, 2005 and February 29, 2004, respectively. The Companys technical support expenses as a percentage of net revenues were 16.2% for the quarter as compared to 17.8% in the same period of the prior fiscal year. The overall decrease of $1.0 million or 21.3% is primarily related to the Company having enhanced its technical support efforts by implementing an automated scheduling tool system resulting in a decrease of customer contacts requiring multiple calls. These operational efficiencies yielded a $0.4 million decrease in contract labor and consultants and a $0.5 million decrease in salaries and benefits. For the six months ended February 28, 2005 technical support expenses were $7.5 million compared to $9.4 million for the six months ended February 29, 2004. As a percentage of revenue, technical support expenses were 16.3% at February 25, 2005 compared to 17.9% at February 29, 2004. The decrease in expenses of $2.0 million or 21% was primarily attributable to a decrease in contract labor of $1.1 million, and a decrease in salaries and benefits of $0.8 for the reasons noted in the quarter comparison above. General and Administrative General and administrative expenses were $7.7 million compared to $7.9 million
for the three months ended February 28, 2005 and February 29, 2004 respectively.
As a percentage of revenues, the Companys general and administrative expenses was 34.1%
for the quarter ended February 28, 2005, as compared to 30.2% in the same period of
the prior year. This decrease of $0.2 million or 1.9% is primarily related to the
reduction in headcount compared to prior year. The primary factors causing the decrease in
general and administrative expenses were a $0.6 million decrease in salaries and
benefits $0.2 million decrease in contract labor, partially offset by a
$0.5 million increase in legal fees and a $0.2 increase in technical and professional fees. For the six months ended February 28, 2005
general and administrative expenses were $14.8 million compared to $16.0 million
for the six months ended February 29, 2004. This decrease of $1.1 million or
7.1% is primarily attributable to the same reduction in headcount as noted in the quarter
comparison above, with reductions of $2.1 million in salaries and benefits, a
$0.3 million decrease in contract labor costs, a $0.2 million decrease in credit
card fees, $0.2 million decrease in office related expenses, and
$0.1 million decrease in travel expenses. Partially offsetting these reductions were
increases in legal expense of $1.0 million, and a $0.8 million increase in
professional fees primarily related to Sarbanes-Oxley certification contractors and consultants. Bad Debt Expense Bad debt expenses were $0.5 million compared to $0.9 million for the three months ended February 28, 2005 and February 29, 2004 respectively. The decrease in bad debt expense is attributable to a decline in customer account write-offs due to our more stringent collection and customer account termination policies for non-payment, resulting in a lower trade accounts receivable balance. For the six months ended February 28, 2005 bad debt expense was $0.9 million compared to $2.1 million for the six months ended February 29, 2004 a reduction of $1.2 million or 56.2%. This decrease is attributable to the same collection efficiencies noted in the quarter comparison above. Depreciation and Amortization Depreciation and amortization expenses were $5.3 million compared to $8.2 million for the three months ended February 28, 2005 and February 29, 2004, respectively. The Companys depreciation and amortization expenses as a percentage of revenues was 23.5% for the quarter ended February 28, 2005, as compared to 31.7% in the same period of the prior year. The decrease in depreciation expense is a result of the continued decline in capital expenditures and the expiration of capital leases during fiscal year 2004. For the six months ended February 28, 2005 depreciation and amortization expense was $11.2 million compared to $16.4 million for the six months ended February 29, 2004. This expense expressed as a percentage of revenue was 24.5% and 31.2% respectively for




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the periods ended February 28, 2005 and February 29, 2004. The decrease in depreciation
expense is a result of the continued decline in capital expenditures and the expiration of capital
leases during fiscal year 2004. Interest Income (Expense), net Interest income (expense) was $0.1 million compared to $(0.2) million for the three months ended
February 28, 2005 and February 29, 2004, respectively. Interest income (expense), net consists of
interest income earned on the Companys combined cash and cash equivalents, short-term investments,
and restricted investments less interest expense on debt, primarily capital leases. The change is
primarily due to the reduction in interest expense relating to the maturing and termination of debt
and leases for capital equipment prior to the quarter and six months ended February 28, 2005. For the six months ended February 28, 2005 interest income (expense) were $0.1 compared to $(0.3)
million for the six months ended February 29, 2004. This decrease in interest expense is primarily
attributable to the same factors noted in the quarter comparison above. Net Cash Used in Operating Activities and Earnings from Continuing Operations Before Interest,
Taxes, Depreciation and Amortization (EBITDA) EBITDA is defined as net income (loss) less (i) provision for income taxes, (ii) interest income or
expense, and (iii) depreciation and amortization. EBITDA is not an indicator of financial
performance under generally accepted accounting principles and may not be comparable to similarly
captioned information reported by other companies. In addition, it does not replace net income
(loss), operating income (loss), or cash flows from operating activities as indicators of operating
performance. The effect of taxes and interest on Interlands net loss is not significant, but
depreciation and amortization, primarily as a result of acquisitions, is significant. The Company
believes that measuring the performance of the business without regard to non-cash depreciation and
amortization can make trends in operating results more readily apparent, and when considered with
other information, assist investors and other users of the Companys financial statements who wish
to evaluate the Companys ability to generate future cash flows. The following table reflects the calculation of EBITDA from continuing operations and a
reconciliation to net cash provided by (used in) operating activities: For the three months ended
    
    
    For the six months endedFebruary 28,
    
    
    February 29,
    
    
    February 28,
    
    
    February 29,2005
    
    
    2004
    
    
    2005
    
    
    2004in thousands
    
    
    in thousandsNet loss
    
    $
    (4,272
    )
    
    $
    (10,100
    )
    
    $
    (7,468
    )
    
    $
    (18,652
    )Depreciation and amortization
    
    
    5,306
    
    
    
    8,241
    
    
    
    11,184
    
    
    
    16,422Interest expense (income)
    
    
    (83
    )
    
    
    166
    
    
    
    (124
    )
    
    
    304Discontinued operations
    
    
    89
    
    
    
    739
    
    
    
    (513
    )
    
    
    1,321EBITDA from continuing operations
    
    $
    1,040
    
    
    $
    (954
    )
    
    $
    3,079
    
    
    $
    (605
    )Interest income / (expense)
    
    
    83
    
    
    
    (166
    )
    
    
    124
    
    
    
    (304
    )Provision for bad debts
    
    
    465
    
    
    
    935
    
    
    
    905
    
    
    
    2,066Loss on the sale of assets
    
    
    72
    
    
    
    (48
    )
    
    
    59
    
    
    
    (71
    )Other non-cash adjustments
    
    
    162
    
    
    
    375
    
    
    
    320
    
    
    
    548Changes in assets and liabilities:Receivables, net
    
    
    (1,044
    )
    
    
    (633
    )
    
    
    (1,534
    )
    
    
    (1,231
    )Other current assets
    
    
    (143
    )
    
    
    176
    
    
    
    158
    
    
    
    540Accounts payable, accrued expenses, and deferred revenue
    
    
    (1,782
    )
    
    
    (4,421
    )
    
    
    (4,365
    )
    
    
    (7,879
    )Net cash provided by (used in) operating activities
    
    $
    (1,147
    )
    
    $
    (4,736
    )
    
    $
    (1,254
    )
    
    $
    (6,936
    )
 For the three and six months ended February 28, 2005, the Companys EBITDA increased $2.0 million
and $3.7 million, respectively, resulting in an EBITDA of $1.0 million and $3.1 million compared to
the same periods of the prior fiscal year. This increase is




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primarily due to the cost savings from
the integration and restructuring efforts during fiscal year 2003 and the decrease in bad debt
expense attributed to the more stringent collection and customer account termination policies. Liquidity and Capital Resources As of February 28, 2005, the Company had $15.8 million in cash and cash equivalents as noted on the
Companys consolidated balance sheet and statement of cash flows. In addition, the Company had $7.5
million in auction rate securities and $10.1 million in short and long-term restricted investments
representing a total of $33.4 million of restricted and unrestricted cash and investments. This
represents a decrease of $5.2 million compared to August 31, 2004. On a comparative basis, cash used in operating activities of continuing operations decreased $5.7
million or 81.9% to $1.3 million for the six months ended February 28, 2005 versus the $6.9 million
of cash used in operating activities for the same period in the prior year. The reduction in cash
used in continuing operations is reflective of the Companys integration initiatives that reduced
facility, bandwidth connectivity and employee related costs. Cash provided by investing activities
decreased $7.1 million or 65.5% to $3.7 million for the six months ended February 28, 2005 versus
$10.8 million of cash provided by investing activities for the same period in the prior year. The
decrease in cash generated from investing activities is primarily related to a reduction in the
investments that were liquidated in order to fund daily cash requirements. Cash used in financing
activities decreased $4.5 million or 74.3% to $1.6 million for the six months ended February 28,
2005 versus the $6.1 million of cash used in financing activities for the same period of prior
year. The decrease in cash used in financing activities is primarily due to the reduction of
overall debt and capital lease obligations. Cash used in discontinued operations decreased $1.1
million or 77.6% for the six months ended February 28, 2005, versus the $1.4 million of cash used
to fund discontinued operations during the same period of the prior year. The primary reason for
the decrease in cash used in discontinued operations is changes in the period cost of litigation,
primarily legal fees associated with the discontinued operations. In February 2004, the Company executed a five-year promissory note with US Bancorp Oliver-Allen
Technology Leasing for $4.8 million. As of February 28, 2005, the principal balance on the
promissory note was $3.9 million. The Company has pledged $5.0 million as collateral for this
promissory note; this amount will gradually decrease until the agreement terminates in February
2009. As of February 28, 2005, the amount of collateral is $4.1 million. These restrictions prevent
the Company from utilizing the related cash and cash equivalents until all of its obligations under
the note are satisfied. The new promissory note bears an interest rate of 6.75% and requires
monthly payments of $93,000 over the next five years. During the first six months of 2005, the Company spent $2.1 million in capital expenditures
primarily related to servers and server components. The Company expects to spend somewhere between
$4.0 million and $7.0 million in capital expenditures during fiscal 2005, primarily related to
purchases of servers and data center equipment on an as-needed basis with as much re-utilization of
equipment from cancelled customers as possible. The Dedicated line of business is particularly
sensitive to capital expenditures since each new customer must be provided with a server, either
newly-purchased, or one which had been provided to a former customer. To the extent that the
dedicated business experiences net growth in customers, additional capital expenditures will be
required. In determining whether to purchase new Dedicated servers, the Company will balance the
cost of the investment against the revenue expected, the operating costs necessary to serve the
customer, and the likely duration of the relationship with the customer. Consequently, decreases in
market pricing and increases in MRC Churn make it more difficult to justify investment. The Companys Web hosting business has historically incurred net losses and losses from operations.
The Companys future operation is dependent upon its ability to achieve and sustain positive cash
flow prior to the depletion of cash resources. The Company has reduced its level of cash
requirements through decreases in capital purchases, reducing operating expenses, and by improving
the ratio of new customer accounts to canceling accounts. Additionally, the Company will have
lower future cash outlays for payments associated with prior integration and discontinued operation
liabilities and reduced debt payments because it settled a number of capital lease obligations
during the prior fiscal year. There can be no assurance that Interlands continuing efforts to
stabilize or increase its revenue will be successful or that the Company will be able to continue
as a going concern. If the Company is unable to successfully execute its business plan, it may
require additional capital, which may not be available on suitable terms. Nonetheless, management
believes it has adequate cash and liquid resources to fund operations and planned capital
expenditures through at least the next 12 months. Recently Issued Accounting Standards In December 2004, the Financial Accounting Standards Board (FASB) issued its final standard on
accounting for share-based payments, FASB Statement No. 123R (revised 2004) (SFAS 123R) that
requires companies to expense the value of employee stock options and similar awards. It requires
a public entity to measure the cost of employee services received in exchange for an award of
equity instruments based on the grant-date, fair value of the award. That cost will be recognized
over the period during which an employee is required to provide service in exchange for the award.
SFAS 123R applies to awards that are granted, modified or settled in interim or fiscal periods
beginning after the effective date. The pro forma disclosures previously permitted under SFAS 123
no longer will be an alternative to financial statement recognition. The adoption of this
standard is required for public entities effective




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as of the beginning of the interim or annual reporting period that starts after June 15, 2005. The company has not yet adopted nor does it expect to early adopt the new standard. The impact
that may result from the adoption of FAS 123R on the companys results of operations, financial
position or its cash flows is not yet known and the Company has not yet selected the valuation
method to be used. However, had we adopted SFAS 123R in prior periods, the impact of that standard
would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net loss and
loss per share in Note 2 to the consolidated financial statements. We expect our earnings and
earnings per share will be adversely affected upon adoption of SFAS No. 123R. During the quarter ended
February 28, 2005, the Company reviewed the accounting treatment of its operating leases in
accordance with FASB Statement 13, Accounting for Leases
and FASB Technical Bulletin 85-3, Accounting for Operating
Leases with Scheduled Rent Increases.
The Company determined that certain of its lease agreements included a provision for modest annual
rent escalation which had not been accounted for in accordance with the applicable Statement.
During the quarter the Company made entries to adjust the balance sheet amount of accrued
liabilities for future rent expense in accordance with SFAS 13, and to record a corresponding
charge to the Companys income statement for the second fiscal
quarter. The adjustment was not material to the quarter ended
February 28, 2005, nor was there a material impact on any prior
quarter. Risk Factors You should carefully consider the following factors and all other information contained in this
Form 10-Q and the Companys Form 10-K for the fiscal year ended August 31, 2004 before you make any
investment decisions with respect to the Companys securities. The risks and uncertainties
described below are not the only risks the Company faces. Interland has incurred losses since inception and could incur losses in the future. Interland has incurred net losses and losses from operations for all but one of each quarterly
period from its inception through the quarter ended February 28, 2005. A number of factors could
increase its operating expenses, such as:  
    Adapting network infrastructure and administrative resources to accommodate additional customers and future growth;
    Developing products, distribution, marketing, and management for the mainstream market;
    Broadening customer technical support capabilities;
    Improving network security features; and;
    Legal fees associated with litigation and contingencies. To the extent that increases in expenses are not offset by increases in revenues, operating
losses will increase. Ours is a recurring-revenue subscriber business and as such the effects of a net loss of monthly
recurring revenue are magnified. A large majority of our revenue is derived from the monthly recurring charges (MRC) incurred by
owners of hosted websites. Accordingly, the termination of a single account paying $30.00 per month
will affect revenue every month in the future. The loss of such a customer at the beginning of a
fiscal year will result in a twelve-fold reduction in revenue for that fiscal year, and the loss of
even one such customer each month of the fiscal year will result in a diminution of 78 times the
monthly recurring revenue, or $2,340 over the entire fiscal year. Absent the addition of customers
through acquisitions, Interland has consistently incurred a net loss in MRC, and this situation may
continue with material negative effects on reported revenue and net income. Although reductions in
MRC may be offset for a time by increases in revenue derived from one-time or non-recurring
charges, the compounding effect of MRC losses will almost certainly eventually result in a
meaningful reduction of reported revenue. Moreover, because of Interlands relatively low
percentage of variable costs, a concomitantly high percentage of the amount of revenue loss results
in a loss of EBITDA and of net income. There can be no assurance that Interlands continuing
efforts to stabilize or increase its MRC and revenue will be successful. If revenue continues to
decline, the Company may eventually require additional capital, which may not be available on
suitable terms. Although the Company can reduce spending to some degree, there can be no assurance
in such an event that the Company would be able to continue indefinitely as a going concern. Because Interlands historical financial information is not representative of its future results,
investors and analysts will have difficulty analyzing Interlands future earnings potential. Because the Company has grown through acquisition and its past operating results reflect the costs
of integrating these acquisitions,




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historical results are not representative of future expected
operating results. The Company has recognized very sizeable charges and expenditures in the past
for impairment charges, restructuring costs, network enhancements, and exploration of the
mainstream market. Because these items are not necessarily recurring, it is more difficult for
investors to predict future results. Interland has a limited operating history and its business model is still evolving, which makes it
difficult to evaluate its prospects. Interlands limited operating history makes evaluating its business operations and prospects
difficult. Its range of service offerings has changed since inception and its business model is still developing. Interland has changed from
being primarily a seller of personal computers and related accessories to being primarily a Web
hosting and Web based value added business solutions provider to
small-and medium-sized businesses company. Because some of its services are new, the market for them is
uncertain. As a result, the revenues and income potential of its business, as well as the potential
benefits of its acquisitions, may be difficult to evaluate. Quarterly and annual operating results may fluctuate, which could cause Interlands stock price to
be volatile. Past operating results have fluctuated significantly on a quarterly and an annual basis. Quarterly
and annual operating results may continue to significantly fluctuate due to a wide variety of
factors. Because of these fluctuations, comparing operating results from period to period is not
necessarily meaningful, and it would not be meaningful to rely upon such comparisons as an
indicator of future performance. Factors that may cause its operating results to fluctuate include,
but are not limited to:  
    Demand for and market acceptance of the Companys services and products;
    Introduction of new services or enhancements by Interland or its competitors;
    Costs of implementing new network security features, CRM systems, and billing modules;
    Technical difficulties or system downtime affecting the Internet generally or its hosting operations specifically;
    Customer retention;
    Increased competition and consolidation within the Web hosting and applications hosting markets;
    Changes in its pricing policies and the pricing policies of its competitors;
    Gains or losses of key strategic partner relationships
    Impairment charges;
    Restructuring charges;
    Merger and integration costs;
    Litigation expenses;
    Insurance expenses;
    Marketing expenses; and
    Seasonality of customer demand Interland cannot provide any assurances that it will succeed in its plans to increase the size of
its customer base, the amount of services it offers, or its revenues during the next fiscal year
and beyond. In addition, relatively large portions of its expenses are fixed in the short term, and
therefore its results of operations are particularly sensitive to fluctuations in revenues. Also,
if it cannot continue using third-party products in its service offerings, its service development
costs could increase significantly. Interlands stock price may be volatile which could cause an investment in its common stock to
decrease significantly. The market price of Interland common stock has experienced a significant decline. The price has
been and is likely to continue to be highly volatile. The following are examples of factors or
developments that would likely cause the Companys stock price to continue to be volatile:




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
    Variations in operating results and analyst earnings estimates;
    The volatility of stock within the sectors within which it conducts business;
    Announcements by Interland or its competitors regarding introduction of new services;
    General decline in economic conditions;
    Reductions in the volume of trading in its common stock and;
    The Companys inability to reduce the rate of account cancellations, or to increase the rate of account additions, or both. During the 52 weeks ended February 28, 2005, the high and low closing price for Interland common
stock on NASDAQ was $5.52 and $2.56, respectively. Interland operates in a new and evolving market with uncertain prospects for growth and may not be
able to achieve and sustain growth in its customer base. Interland operates in a new and evolving market with uncertain prospects for growth and may not be
able to achieve and sustain growth in its customer base or to maintain its average revenue per
customer account. The market for Web hosting and applications-hosting services for small- and
medium-sized businesses, and especially the mainstream market, has only recently begun to develop
and is evolving rapidly. The market for Interlands services may not develop further, consumers
may not widely adopt its services and significant numbers of businesses or organizations may not
use the Internet for commerce and communication. If this market fails to develop further or
develops more slowly than expected, or if Interlands services do not achieve broader market
acceptance, Interland will not be able to grow its customer base. In addition, Interland must be
able to differentiate itself from its competition through its service offerings and brand
recognition. These activities may be more expensive than Interland anticipates, and Interland may
not succeed in differentiating itself from its competitors, achieving market acceptance of its
services, or selling additional services to its existing customer base. Because Interlands target markets are volatile, the Company may face a loss of customers or a high
level of non-collectible accounts. The Company intends to continue to concentrate on serving the small- and medium-sized business
market. This market contains many businesses that may not be successful, and consequently present
a substantially greater risk for non-collectible accounts receivable and for non-renewal. Moreover,
a significant portion of this target market is highly sensitive to price, and may be lost to a
competitor with a lower pricing structure. Because few businesses in this target market employ
trained technologists, they tend to generate a high number of customer service and technical
support calls. The expense of responding to these calls is considerable, and the call volume is
likely to increase in direct proportion to revenue, potentially limiting the scalability of the
business. Additionally, if the customer becomes dissatisfied with the Companys response to such
calls, cancellation, non-payment, or non-renewal becomes more likely. Interlands strategy for
minimizing the negative aspects of its target market include:  
    Capitalizing on infrastructure efficiencies to become a profitable provider at the lowest
sustainable price;
    Automating customer care and technical support to reduce the cost per call, and
to minimize the time spent by Company personnel;
    Intensive training and supervision of customer care and technical support
personnel to maximize customer satisfaction; and,
    Increasing the number and breadth of services to differentiate the Company from
competition. The Company can give no assurance, however, that any of these measures will be successful, and the
Companys failure to manage these risks could decrease revenues and profitability. If we fail to achieve and maintain effective internal controls this could have a material adverse
effect on our business, operating results and stock price. We are in the process of documenting and testing our internal control procedures in order to
satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management
assessments of the effectiveness of our internal controls over financial reporting and a report by
our Independent Auditors addressing these assessments. The Company is required to file
the first assessment




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and report in connection with its annual report on Form 10-K which must be
filed prior to November 14, 2005. During the course of our testing we may identify deficiencies
which we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley
Act for compliance with the requirements of Section 404. In addition, if we fail to achieve and
maintain the adequacy of our internal controls, as such standards are modified, supplemented or
amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis
that we have effective internal controls over financial reporting in accordance with Section 404 of
the Sarbanes-Oxley Act. Moreover, effective internal controls, particularly those related to
revenue recognition, are necessary for us to produce reliable financial reports and are important
to helping prevent financial fraud. If we cannot provide reliable financial reports or prevent
fraud, our business and operating results could be harmed. Investors could lose confidence in our
reported financial information, and the trading price of our stock could drop significantly. Interland could incur liabilities in the future relating to its PC Systems business, which could
cause additional operating losses. Interland could incur liabilities from the sale of the PC Systems business to GTG PC. According to
the terms of its agreement with GTG PC, it retained liabilities relating to the operation of the PC systems business prior to the
closing of the transaction including liabilities for taxes, contingent liabilities and liabilities
for accounts payable accrued prior to the closing. It also agreed to indemnify GTG PC and its
affiliates for any breach of its representations and warranties contained in the agreement for a
period of two years, or for the applicable statute of limitations for matters related to taxes. Its
indemnification obligation is capped at $10.0 million. Except for claims for fraud or injunctive
relief, this indemnity is the exclusive remedy for any breach of its representations, warranties
and covenants contained in the agreement with GTG PC. Accordingly, it could be required in the
future to make payments to GTG PC and its affiliates in accordance with the agreement, which could
adversely affect its future results of operations and cash flows. To date it has not had to
satisfy any such claims. Because Interland faces intense competition, it may not be able to operate profitably in its
markets. The Web hosting and applications hosting markets are highly competitive, which could hinder
Interlands ability to successfully market its products and services. The Company may not have the
resources, expertise or other competitive factors to compete successfully in the future. Because
there are few substantial barriers to entry, the Company expects that it will face additional
competition from existing competitors and new market entrants in the future. Many of Interlands
current and potential competitors have greater name recognition and more established relationships
in the industry and greater resources. As a result, 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;
    Devote greater resources to the marketing and sale of their services; and,
    Adopt more aggressive pricing policies than the Company can. Current and potential competitors in the market include Web hosting service providers, applications
hosting providers, Internet service providers, telecommunications companies, large information
technology firms and computer hardware suppliers. These competitors may operate in one or more of
these areas and include companies such as Yahoo!, NTT/Verio, Affinity Internet, and Earthlink. Impairment of Interlands intellectual property rights could negatively affect its business or
could allow competitors to minimize any advantage that Interlands proprietary technology may give
it. The Company currently has no patented technology that would preclude or inhibit competitors from
entering the Web hosting market that it serves. While it is the Companys practice to enter into
agreements with all employees and with some of its customers and suppliers to prohibit or restrict
the disclosure of proprietary information, the Company cannot be sure that these contractual
arrangements or the other steps it takes to protect its proprietary rights will prove sufficient to
prevent illegal use of its proprietary rights or to deter independent, third-party development of
similar proprietary assets. Effective copyright, trademark, trade secret and patent protection may not be available in every
country in which its products and services are offered. Interland currently is, and in the future
may be, involved in legal disputes relating to the validity or alleged infringement of its
intellectual property rights or those of a third party. Intellectual property litigation is
typically extremely costly and can be disruptive to business operations by diverting the attention
and energies of management and key technical personnel. In addition, any adverse decisions could
subject it to significant liabilities, require it to seek licenses from others, prevent it from
using, licensing or selling certain of its products and services, or cause severe disruptions to
operations or the markets in which it competes which could decrease profitability. Periodically, it is made aware of claims, or potential claims, that technology it used in its
discontinued operations may have infringed on intellectual property rights held by others. The
Company has accrued a liability and charged operations for the estimated costs of




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settlement or adjudication of several asserted and unasserted claims for alleged infringement relating to its
discontinued operations prior to the balance sheet date. Resolution of these claims could be
costly and decrease profitability If Interland is unable to attract and retain key personnel, it may not be able to compete
effectively in its market. The future success of Interland will depend, in part, on its ability to attract and retain key
management, technical, and sales and marketing personnel. The Company attempts to enhance its
management and technical expertise by recruiting qualified individuals who possess desired skills
and experience in certain targeted areas. The Company experiences strong competition for such
personnel in the Web hosting industry. The Companys inability to retain employees and attract and
retain sufficient additional employees, information technology, engineering, and technical support
resources could adversely affect its ability to remain competitive in its markets. The Company has
and may continue to face the loss of key personnel, which could limit the ability of the Company to
develop and market its products and services. Interland depends on its reseller sales channel to market and sell many of its services. Interland
does not control its resellers, and if it fails to develop or maintain good relations with
resellers, it may not achieve the growth in customers and revenues that it expects. An element of the strategy for the Companys growth is to further develop the use of third parties
that resell or recommend its services. Many of these resellers are Web development or Web
consulting companies that also sell Interlands Web hosting services,
but that generally do not have established customer bases to which they can market these services.
The Company is not currently dependent on any one reseller to generate a significant level of
business, but it has benefited and continues to significantly benefit from business generated by
the reseller channel. Although Interland attempts to provide its resellers with incentives such as
price discounts on its services that the resellers seek to resell at a profit, the failure of its
services to be commercially accepted in some markets, whether as a result of a resellers
performance or otherwise, could cause its current resellers to discontinue their relationships
with the Company. The Company also is developing relationships with larger distribution partners,
and although the percentage of the Companys current revenues generated by any of these
relationships is currently small, if the Companys strategy is successful, future revenue growth
will be dependent on the success and maintenance of these relationships. Interland is vulnerable to system failures, which could harm its reputation, cause its customers to
seek reimbursement for services, and cause its customers to seek another provider for services. The Company must be able to operate the systems that manage its network around the clock without
interruption. Its operations will depend upon its ability to protect its network infrastructure,
equipment and customer files against damage from human error, fire, earthquakes, hurricanes,
floods, power loss, telecommunications failures, sabotage, intentional acts of vandalism and
similar events. The Companys networks are currently subject to various points of failure. For
example, a problem with one of its routers (devices that move information from one computer network
to another) or switches could cause an interruption in the services the Company provides to a
portion of its customers. In the past, the Company has experienced periodic interruptions in
service. The Company has also experienced, and in the future it may continue to experience, delays
or interruptions in service as a result of the accidental or intentional actions of Internet users,
current and former employees, or others. Any future interruptions could:  
    Cause customers or end users to seek damages for losses incurred;
    Require the Company to replace existing equipment or add redundant facilities;
    Damage the Companys reputation for reliable service;
    Cause existing customers to cancel their contracts; or
    Make it more difficult for the Company to attract new customers. Interlands data centers and network vulnerability to security breaches could cause disruptions in
its service, liability to third parties, or loss of customers. A significant barrier to electronic commerce and communications is the need for secure transmission
of confidential information over public networks. Some of the Companys services rely on security
technology licensed from third parties that provides the encryption and authentication necessary to
effect the secure transmission of confidential information. Despite the design and implementation
of a variety of network security measures by the Company, unauthorized access, computer viruses,
accidental or intentional actions and other disruptions could occur. In addition, inappropriate use
of the network by third parties could also potentially jeopardize the security of confidential
information, such as credit card and bank account numbers stored in the Companys computer systems.
These security problems could result in the Companys liability and could also cause the loss of
existing customers and potential customers. Although the Company continues to implement industry-standard security measures, third parties may
be able to overcome any




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measures that it implements. The costs required to eliminate computer viruses and alleviate other security problems could be prohibitively expensive and the efforts to
address such problems could result in interruptions, delays or cessation of service to customers,
and harm the Companys reputation and growth. Concerns over the security of Internet transactions
and the privacy of users may also inhibit the growth of the Internet, especially as a means of
conducting commercial transactions. Disruption of Interlands services caused by unknown software or hardware defects could harm its
business and reputation. The Companys service offerings depend on complex software and hardware, including proprietary
software tools and software licensed from third parties. Complex software and hardware may contain
defects, particularly when first introduced or when new versions are released. The Company may not
discover software or hardware defects that affect its new or current services or enhancements until
after they are deployed. Although Interland has not experienced any material software or hardware
defects to date, it is possible that defects may exist or occur in the future. These defects could
cause service interruptions, which could damage its reputation or increase its service costs, cause
it to lose revenue, delay market acceptance or divert its development resources. Providing services to customers with critical websites and Web-based applications could potentially
expose Interland to lawsuits for customers lost profits or other damages. Because the Companys Web hosting and applications hosting services are critical to many of its
customers businesses, any significant interruption in those services could result in lost profits or other indirect or
consequential damages to its customers as well as negative publicity and additional expenditures
for it to correct the problem. Although the standard terms and conditions of the Companys customer
contracts disclaim liability for any such damages, a customer could still bring a lawsuit against
it claiming lost profits or other consequential damages as the result of a service interruption or other website or
application problems that the customer may ascribe to it. A court might not enforce any limitations
on its liability, and the outcome of any lawsuit would depend on the specific facts of the case and
legal and policy considerations even if the Company believes it would have meritorious defenses to
any such claims. In such cases, it could be liable for substantial damage awards. Such damage
awards might exceed its liability insurance by unknown but significant amounts, which would
seriously harm its business. Interland could face liability for information distributed through its network. The law relating to the liability of online services companies for information carried on or
distributed through their networks is currently unsettled. Online services companies could be
subject to claims under both United States and foreign law for defamation, negligence, copyright or
trademark infringement, violation of securities laws or other theories based on the nature and
content of the materials distributed through their networks. Several private lawsuits seeking to
impose such liability upon other entities are currently pending against other companies. In
addition, organizations and individuals have sent unsolicited commercial e-mails from servers
hosted by service providers 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. The
Company may, in the future, receive letters from recipients of information transmitted by its
customers objecting to such transmission. Although the Company prohibits its customers by contract
from spamming, it cannot provide assurances that its customers will not engage in this practice,
which could subject it to claims for damages. In addition, the Company may become subject to
proposed legislation that would impose liability for or prohibit the transmission over the Internet
of some types of information. Other countries may also enact legislation or take action that could
impose liability on the Company or cause it not to be able to operate in those countries. The
imposition upon the Company and other online services of potential liability for information
carried on or distributed through its systems could require it to implement measures to reduce its
exposure to this liability, which may require it to expend substantial resources, or to discontinue
service offerings. The increased attention focused upon liability issues as a result of these
lawsuits and legislative proposals also could affect the rate of growth of Internet use. Interlands business operates in an uncertain legal environment where future government regulation
and lawsuits could restrict Interlands business or cause unexpected losses. Due to the increasing popularity and use of the Internet, laws and regulations with respect to the
Internet may be adopted at federal, state and local levels, covering issues such as user privacy,
freedom of expression, pricing, characteristics and quality of products and services, taxation,
advertising, intellectual property rights, information security and the convergence of traditional
telecommunications services with Internet communications. The Company cannot fully predict the
nature of future legislation and the manner in which government authorities may interpret and
enforce such legislation. As a result, Interland and its customers could be subject to potential
liability under future legislation, which in turn could have a material adverse effect on the
Companys business. The adoption of any such laws or regulations might decrease the growth of the
Internet which in turn could decrease the demand for the Companys services, or increase the cost
of doing business. In addition, applicability to the Internet of existing laws governing issues
such as property ownership, copyright and other intellectual property issues, taxation, libel,
obscenity and personal privacy is uncertain. These laws generally pre-date the advent of the
Internet and related technologies and, as a result, do not consider or address the unique issues of
the Internet and related technologies.




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Substantial future sales of shares by shareholders could negatively affect Interlands stock price. A number of groups of investors hold substantial numbers of Interland shares, including the former
shareholders of acquired companies, and hedge funds reported to have investment styles that lead to
short-term holdings. Substantial sales by these holders may adversely affect Interlands stock
price. 
 Item 3. Quantitative And Qualitative Disclosures About Market Risk Substantially all of the Companys liquid investments and a majority of its debt are at fixed
interest rates, and therefore the fair value of these instruments is affected by changes in market
interest rates. As of February 28, 2005, approximately 95% of the Companys liquid investments,
including auction rate securities, mature or have interest rate reset periods within three months
and 5% mature or have reset periods within one year. As of February 28, 2005, management believes
the reported amounts of liquid investments and debt to be reasonable approximations of their fair
values. Generally, the fair market value of fixed interest rate investment securities will increase
as interest rates fall and decrease as interest rates rise. The Company does not use derivative
financial instruments in its investment portfolio. The portfolio has been primarily comprised of
auction rate securities, commercial paper rated A1/P1, bank certificates rated AA or better, and
corporate medium-term notes rated AA or better. At February 28, 2005, the Companys investment
portfolio included fixed rate securities with an estimated fair value of $21.0 million, which
approximates the Companys carrying value. The interest rate changes affect the fair market values
but do not impact earnings or cash flows. The fair market value of long-term fixed interest rate
debt is also subject to interest rate risk. Generally, the fair market of fixed interest rate debt
will increase as interest rates fall and decrease as interest rates rise. The estimated fair value
of the Companys long-term debt at February 28, 2005 was $3.0 million, which approximates the Companys carrying value. 
 Item 4. Controls And Procedures The Companys management, including its chief executive officer, chief financial officer and
chief accounting officer evaluated the effectiveness of the Companys disclosure controls and
procedures (as defined in the Securities Exchange Act of 1934 Rules 13(a)  14(c), and 14(d)) as of
February 28, 2005. Based on this review, the chief executive officer, chief financial officer and
chief accounting officer concluded that Interlands disclosure controls and procedures were
effective to provide reasonable assurances that such disclosure controls and procedures satisfy
their objectives and that the information required to be disclosed by the Company in its periodic
reports is accumulated and communicated to management, including its chief executive officer, chief
financial officer and chief accounting officer, as appropriate to allow timely decisions regarding
disclosure and is recorded, processed, summarized and reported within the time periods specified in
the U.S. Securities and Exchange Commissions rules and forms. Because of its inherent limitations, internal controls over financial reporting may not prevent or
detect misstatements. Also, projections of any evaluation of effectiveness to future periods are
subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate. The Company considers a change in its internal control over financial reporting to be material only
when the failure to effectuate such change would result in a more than a remote likelihood that a
material misstatement of the Companys annual or interim financial statements would not have been
prevented or detected. During the second fiscal quarter, there were no changes in the Companys
internal control over financial reporting which management considered to be material.




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Interland, Inc. 
 PART II.  OTHER INFORMATION 
 Item 1. Legal Proceedings In February of 2003, the Company filed a lawsuit in Cobb County, Georgia against Mr.
Gabriel Murphy, one of the former principals of Interlands subsidiary, CommuniTech.Net, Inc.
(Communitech), which was acquired by Interland in February 2002. The Companys lawsuit claims,
among other things, that Mr. Murphy breached certain covenants under his employment agreement
and also demands payment from Mr. Murphys two promissory notes (one of which was non-recourse
while the other was recourse). In March 2004, Interland retired the 273,526 shares of stock
held as collateral and wrote off the $2,000,000 non-recourse promissory note, which had been
carried as Stockholders Equity. The other $735,000 full recourse promissory note remains
outstanding and continues to be a subject of the Cobb County litigation noted herein. Mr.
Murphy has asserted various counterclaims in response. In February 2003, Mr. Heitman, also a former principal of Interlands subsidiary Communitech,
and Mr. Murphy filed a lawsuit against Interland, its Chief Executive Officer, Mr. Joel Kocher,
and Communitech, in Jackson County, Missouri claiming, among other things, that Interland acted
unreasonably in failing to have the S-3 registration statement declared effective by the SEC on
a timely basis and claiming that Interland and/or Mr. Kocher made inaccurate disclosures in
connection with Interlands acquisition of Communitech. The complaint sought compensatory and
punitive damages in an unspecified amount. Interland believes that these claims are without
merit and will not have a material adverse effect on Interland and is vigorously defending the
claims. The Interland parties have filed motions to dismiss all of the claims against them and
those motions are pending. Interland is defending another case in Jackson County, Missouri arising out of the shutdown of
five unregistered servers at the Communitech data center in February 2003. An entity called
Bent Axis and its principle owner, Jason Park, have filed suit against the Company and its
General Counsel, Jonathan Wilson, alleging a variety of contract and tort claims. In its first
complaint, Bent Axis asserted that it owned the five servers in question. It later amended its
pleading to assert a different theory: that it was using the servers by permission of certain
Interland personnel. Bent Axis claims that it was damaged when the Company disconnected the
servers in question, although Bent Axis has produced no documentary evidence that it had ever
generated a profit or that it had any right to use the servers in question. The Company is
vigorously defending the suit and believes that it will not have a material adverse effect on
Interland. In February 2004, the Company initiated a lawsuit in the United States District Court for the
Northern District of Georgia against the representatives of the former shareholders of
Hostcentric (the Hostcentric Shareholders), seeking a declaratory judgment that it will be
entitled to reimbursement from the escrow fund established as part of the Hostcentric
acquisition for any amounts over $180,000 that it may be required to pay to the landlord for a
leased facility in Farmingdale, New York, in accordance with the acquisition agreement between
the Company and Hostcentric and its shareholders. The representatives of the Hostcentric
Shareholders have denied Interlands claims and have attempted to assert various counterclaims.
The Company, has in turn, brought additional claims based on facts learned in discovery.
Correspondence between the parties has also discussed the possibility of other claims, but these
claims have not yet been asserted in litigation. Interland believes its claims in this case
are meritorious, that the counterclaims of the former Hostcentric shareholders are without
merit, plans to continue to contest the matter vigorously and believes that no material adverse
effect on Interland will occur as a result of this litigation. In February 2004, the Company, through its Hostcentric subsidiary, has also initiated a lawsuit
in United States District Court for Southern District of New York against the landlord for the
same Farmingdale, New York facility. The Company believes that it and the landlord have reached
an agreement in principle to settle the litigation and has petitioned the court to enforce the
agreement. Interland believes that no material adverse effect on Interland will occur as a
result of this litigation. Interland is the defendant in a case involving the Telephone Communications Privacy Act (TCPA)
in state court in Allegheny County, Pennsylvania. A competing web hosting company,
PairNetworks, filed this case in December 2001 as a class action, claiming that Interlands
distribution of a facsimile on November 15, 2001 to market domain name registration services
violated the TCPA. Several years later, two additional plaintiffs joined in the action, each of
whom is a former customer of Interland. The plaintiffs have conceded that Interland distributed
the facsimile to approximately 38,000 recipients who were customers of Interland. Federal
Communications Commission regulations in effect at the time provided that the distribution of
facsimiles to persons with whom the sender had an established business relationship did not
amount to a violation of the TCPA. Interland has asked the court to deny class certification
and a ruling on that motion is pending as well as our motion for summary judgment. If the
court denies class certification, Interlands damages, if it were liable, cannot exceed $1,500
for each of the three putative plaintiffs. Interland believes the plaintiffs claims are
without merit, plans to continue to contest the matter vigorously and believes that no material
adverse effect on Interland will occur as a result of this litigation. The Company is defending a case in federal court in the Southern District of Florida arising out
of the management of a co-




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located server by its predecessor company, Worldwide Internet Publishing Corporation.
The suit alleges that the Company is responsible for the loss of Plaintiffs internet search
engine that occurred after the departure of the officer managing the server, Mark Ismach, in or
around March 2000. Interland believes that it has meritworthy defenses to the claims including
provisions in the contract for the services that exclude the damages sought by Plaintiff.
Interland believes the plaintiffs claims are without merit, plans to continue to contest the
matter vigorously and believes that no material adverse effect on Interland will occur as a
result of this litigation. On January 23, 2004, Vincent Salazar, an individual, sued Interland and its predecessor HostPro,
claiming that he was entitled to money as a result of his alleged involvement in brokering
Interlands acquisition of accounts from AT&T in January 2002. The case is pending in federal
court in Los Angeles. The Plaintiff asserted fraud and breach of contract claims (the fraud
claim was dismissed by the court) and has alleged that he is due 20% of the revenue that
Interland has received from the acquired accounts. Interland believes it has meritorious
defenses, including the fact that HostPros contract with Mr. Salazar, a channel partner
arrangement, prohibits the recovery he is seeking. Interland believes the plaintiffs claims
are without merit, plans to continue to contest the matter vigorously and believes that no
material adverse effect on Interland will occur as a result of this litigation. In February 2004, Interland was served with a suit filed by NetGlobal Marketing against
Interland and its predecessor, Dialtone, asserting claims for lost data. Interland had
cancelled NetGlobals web hosting accounts in January 2003 as a result of complaints that the
server was being used to send spam and Interland has asserted counterclaims arising from the
incidents. Interland filed a motion to dismiss in favor of arbitration which was denied and
Interland has appealed that decision to the Ninth Circuit Court of Appeals. Interland believes
that, even if the litigation proceeds, it has adequate defenses including provisions in the
contract with the plaintiff that shield Dialtone from damages for erasure and loss of data
and generally prohibit recovery of the kind of damages sought by plaintiff. Interland believes
the plaintiffs claims are without merit, plans to continue to contest the matter vigorously and
believes that no material adverse effect on Interland will occur as a result of this litigation. Interland is defending an arbitration proceeding pending in Atlanta, Georgia before the American
Arbitration Association filed by SmartText Corporation. In August 2003, SmartText filed an
action in federal court in Kansas. The case was dismissed in favor of arbitration in February
2004 after a jury trial. SmartText Corp. v. Interland, Inc., 296 F.Supp.2d 1257, 1262-63
(D.Kan. 2003). SmartText is claiming damages suffered as a result of Interlands migration of
its website around January 2002 including loss of revenue, costs for rebuilding the website and
the reconstruction of lost software located on the site. Interlands contract with the customer
contains a general limitation of liability and waivers of the specific damages allegedly
suffered by SmartText. Interland believes the plaintiffs claims are without merit, plans to
continue to contest the matter vigorously and believes that no material adverse effect on
Interland will occur as a result of this litigation. Interland is also defending a case entitled Novell, Inc. v. Micron Electronics, Inc. filed in
August 1999 in state court in Utah County, Utah. Novell claims that it was underpaid for
royalties on sales of several versions of its NetWare software purportedly distributed by
Interlands predecessor, Micron Electronics, between 1996 and 1998. In addition, Novell also
believes it is entitled additional royalties for sales of the software purportedly distributed
by NetFrame between 1993 and 1997. Micron Electronics acquired NetFrame in 1997. Novell is
seeking an accounting and damages. Interland believes it has meritworthy defenses to Novells
claims. The litigation is still in the discovery phase. Periodically, the Company is made aware that technology it used in its discontinued operations
may have infringed on intellectual property rights held by others. The Company has evaluated all
such claims and, if necessary and appropriate, sought to obtain licenses for the use of such
technology. If the Company or its suppliers were unable to obtain licenses necessary to use
intellectual property in its discontinued operations products or processes, it may be forced to
defend legal actions taken against it relating to allegedly protected technology. The Company
evaluates all such claims and has accrued a liability and charged discontinued operations for
the estimated costs of settlement or adjudication of claims for alleged infringement as of the
respective dates of the balance sheets included in this report. The Company is also a defendant in a number of other lawsuits that the Company regards as
unlikely to result in any material payment; nonetheless, the outcome of litigation may not be
assured, and the Companys cash balances could be materially affected by an adverse judgment. In
accordance with SFAS No. 5 Accounting for Contingencies, the Company believes it has
adequately reserved for the contingencies arising from the above legal matters where an outcome
was deemed to be probable and the loss amount could be reasonably estimated. As such, the
Company does not believe that the anticipated outcome of the aforementioned proceedings will
have a materially adverse impact on its results of operations, its financial condition or its
cash flows.




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Item 2. Unregistered Sale of Equity Securities and Use of Proceeds Not Applicable 
 Item 3. Defaults Upon Senior Securities Not Applicable 
 Item 4. Submission of Matters to a Vote of Security Holders Not Applicable 
 Item 5. Other Information Not Applicable 
 Item 6. Exhibits Exhibits: Exhibit
    
    Description3.01
    
    Unofficial Restated Articles of Incorporation of Registrant (as amended through April 24, 2002)
(incorporated by reference to the Registrants Quarterly Report on Form 10-Q for the quarter ended
5/31/02).3.01(b)
    
    Articles of Amendment to Articles of Incorporation of Registrant (incorporated by reference to the
Registrants Annual Report on Form 10-K for the year ended 8/31/03).3.02
    
    Unofficial Restated Bylaws of the Registrant (as amended through April 24, 2002) (incorporated by
reference to the Registrants Quarterly Report on Form 10-Q for the quarter ended 5/31/02).31.1
    
    Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002.




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Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized. Interland, Inc.(Registrant)Dated: April 4, 2005
    
    /s / Allen L. ShulmanAllen L. ShulmanSenior Vice President, Chief Financial Officer,and Executive Counsel(Principal Financial Officer)