##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 Form 10-Q [X] 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 [X] No [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [  ] The number of outstanding shares of the registrants Common Stock on November
30, 2004 was 16,092,602.    1




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##### Table of Contents



PART I. Financial Information
    
    
    3Item 1. 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
    
    
    26Item 1. Legal Proceedings
    
    
    26Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    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
 2




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##### Table of Contents



PART I. Financial Information 
 Item 1. Financial Statements Interland, Inc. 
 Consolidated Statements Of Operations (In thousands except per share amounts)
(Unaudited) For the three months endedNovember 30,
    
    November 30,2004
    
    2003Revenues
    
    $
    23,061
    
    

    $
    26,687Operating costs and expenses:Network operating costs, exclusive of depreciation shown below
    
    
    5,685
    
    
    
    7,099Sales and marketing, exclusive of depreciation shown below
    
    
    3,966
    
    
    
    5,206Technical support, exclusive of depreciation shown below
    
    
    3,813
    
    
    
    4,805General and administrative, exclusive of depreciation shown below
    
    
    7,131
    
    
    
    8,123Bad debt expense
    
    
    440
    
    
    
    1,131Depreciation and amortization
    
    
    5,877
    
    
    
    8,182Other expense (income), net
    
    
    (13
    )
    
    
    (26
    )Total operating costs and expenses
    
    
    26,899
    
    
    
    34,520Operating loss
    
    
    (3,838
    )
    
    
    (7,833
    )Interest income (expense), net
    
    
    41
    
    
    
    (138
    )Loss from continuing operations before taxes
    
    
    (3,797
    )
    
    
    (7,971
    )Income tax benefit (expense)
    
    
    
    
    
    
    Net loss from continuing operations
    
    
    (3,797
    )
    
    
    (7,971
    )Gain (loss) from discontinued operations, net of tax
    
    
    601
    
    
    
    (582
    )Net loss
    
    $
    (3,196
    )
    
    $
    (8,553
    )Net gain (loss) per share, basic and diluted:Continuing operations
    
    $
    (0.24
    )
    
    $
    (0.49
    )Discontinued operations
    
    
    0.04
    
    
    
    (0.04
    )$
    (0.20
    )
    
    $
    (0.53
    )Number of shares used in per share calculation:Basic and diluted
    
    
    16,016
    
    
    
    16,163
 The accompanying notes are an integral part of these consolidated financial statements. 3




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Interland, Inc. 
 Consolidated Balance Sheets (In thousands)
(Unaudited) As ofNovember 30,
    
    August 31,2004
    
    2004AssetsCash and cash equivalents
    
    $
    23,157
    
    
    $
    25,228Short term investments
    
    
    3,000
    
    
    
    2,500Trade receivables, net
    
    
    2,478
    
    
    
    2,431Other receivables
    
    
    556
    
    
    
    553Other current assets
    
    
    3,178
    
    
    
    3,479Restricted investments
    
    
    283
    
    
    
    283Total current assets
    
    
    32,652
    
    
    
    34,474Restricted investments
    
    
    10,093
    
    
    
    10,609Property plant and equipment, net
    
    
    21,156
    
    
    
    24,508Intangibles, net
    
    
    10,392
    
    
    
    12,077Other assets
    
    
    3,244
    
    
    
    3,244Total assets
    
    $
    77,537
    
    
    $
    84,912Liabilities and shareholders equityAccounts payable
    
    $
    1,060
    
    
    $
    2,517Accrued expenses
    
    
    12,073
    
    
    
    12,105Accrued restructuring charges
    
    
    3,796
    
    
    
    4,393Current portion of long-term debt and capital lease obligations
    
    
    1,557
    
    
    
    2,271Deferred revenue
    
    
    7,353
    
    
    
    7,777Total current liabilities
    
    
    25,839
    
    
    
    29,063Long-term debt and capital lease obligations
    
    
    3,247
    
    
    
    3,473Deferred revenue, long-term
    
    
    234
    
    
    
    268Other liabilities
    
    
    2,352
    
    
    
    3,209Total liabilities
    
    
    31,672
    
    
    
    36,013Commitments and contingencies
    
    
    
    
    
    
    Shareholders equityCommon stock, $.01 par value, authorized 21 million shares,
issued and outstanding 16.1 million and 16.1 million shares,
respectively
    
    
    161
    
    
    
    161Additional capital
    
    
    321,095
    
    
    
    321,091Warrants
    
    
    4,603
    
    
    
    4,603Deferred compensation
    
    
    (162
    )
    
    
    (320
    )Note receivable from shareholder
    
    
    (735
    )
    
    
    (735
    )Accumulated deficit
    
    
    (279,097
    )
    
    
    (275,901
    )Total shareholders equity
    
    
    45,865
    
    
    
    48,899Total liabilities and shareholders equity
    
    $
    77,537
    
    
    $
    84,912
 The accompanying notes are an integral part of these consolidated financial statements. 4




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Interland, Inc. 
 Consolidated Statements of Cash Flows (In thousands)
(Unaudited) For the three months endedNovember 30,
    
    November 30,2004
    
    2003CASH FLOWS FROM OPERATING ACTIVITIESNet loss
    
    $
    (3,196
    )
    
    $
    (8,553
    )Adjustments to reconcile net loss to net cash used in operating activities from continuing operations:(Income) loss from discontinued operations
    
    
    (601
    )
    
    
    582Depreciation and amortization
    
    
    5,877
    
    
    
    8,182Bad debt expense
    
    
    440
    
    
    
    1,131Gain on sale of assets
    
    
    (13
    )
    
    
    (22
    )Other non-cash adjustments
    
    
    158
    
    
    
    173Changes in operating assets and liabilities net of effect of acquisitions:Receivables, net
    
    
    (490
    )
    
    
    (598
    )Other current and non current assets
    
    
    301
    
    
    
    364Accounts payable, accrued expenses, other liabilities and deferred revenue
    
    
    (2,583
    )
    
    
    (3,459
    )Cash used in operating activities of continuing operations
    
    
    (107
    )
    
    
    (2,200
    )CASH FLOWS FROM INVESTING ACTIVITIESExpenditures for property, plant, and equipment
    
    
    (827
    )
    
    
    (2,453
    )Purchases of held-to-maturity investment securities
    
    
    (500
    )
    
    
    (1,500
    )Proceeds from held-to-maturity investment securities
    
    
    
    
    
    
    11,300Net change in restricted investments
    
    
    516
    
    
    
    1,293Acquisitions, net of cash acquired
    
    
    
    
    
    
    (23
    )Cash provided by (used in) investing activities of continuing operations
    
    
    (811
    )
    
    
    8,617CASH FLOWS FROM FINANCING ACTIVITIESRepayments of debt and capital lease obligations
    
    
    (940
    )
    
    
    (3,497
    )Proceeds from issuance of common stock
    
    
    4
    
    
    
    Cash used in financing activities of continuing operations
    
    
    (936
    )
    
    
    (3,497
    )Net cash provided by continuing operations
    
    
    (1,854
    )
    
    
    2,920Net cash (used in) provided by discontinued operations
    
    
    (217

    )
    
    
    (601
    )Net increases (decreases) in cash and cash equivalents
    
    
    (2,071
    )
    
    
    2,319Cash and cash equivalents at beginning of period
    
    
    25,228
    
    
    
    35,255Cash and cash equivalents at end of period
    
    $
    23,157
    
    
    $
    37,574
 The accompanying notes are an integral part of these consolidated financial statements 5




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Interland, Inc. 
 Notes To Consolidated Financial Statements  1.
    
    General Business 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
one reporting segment and continues to offer 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
plans to reduce its level of cash requirements through a decrease in capital
purchases and by improving sales and reducing customer churn. The Company
will have reduced cash outlays for payments associated with prior integration
and discontinued operation liabilities and reduced debt payments because of
the buyout of capital lease obligations during fiscal 2004. The Company
expects to continue to have negative cash flows for at least the next three
quarters as it continues to execute on its business plan. There can be no
assurance that Interlands continuing efforts to stabilize or increase its
revenue will be successful and 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 Policies Interim Unaudited Financial Information The accompanying unaudited
consolidated financial statements for the three-month periods ended November
30, 2004 and November 30, 2003, 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 presentation of the results of
the interim periods shown. All adjustments are of a normal recurring nature
unless otherwise disclosed. Operating results for the three-month period
ended November 30, 2004 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 first
quarter ended November 30, 2004 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. 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, the
following table illustrates the effect on net loss and loss per share: Three-month period endedNovember 30,
    
    November 30,2004
    
    2003in thousands, except per share numbersNet loss as reported
    
    $
    (3,196
    )
    
    $
    (8,553
    )Add: Stock-based employee compensation expense included in
reported net income, net of related tax effects
    
    
    158
    
    
    
    174Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards, net of
tax effects
    
    
    (416
    )
    
    
    (576
    )
 6




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Interland, Inc.Notes To Consolidated Financial Statements (Continued) Three-month period endedNovember 30,
    
    November 30,2004
    
    2003in thousands, except per share numbersProforma net loss
    
    $
    (3,454
    )
    
    $
    (8,955
    )Loss per share:Basic and diluted  as reported
    
    $
    (0.20
    )
    
    $
    (0.53
    )Basic and diluted  pro forma
    
    $
    (0.22
    )
    
    $
    (0.55
    )Weighted average shares outstanding Basic and diluted
    
    
    16,016
    
    
    
    16,163
  3.
    
    Restructuring And Facility Exit Costs 2001 Plan During 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. In accordance with EITF No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit
an Activity, the restructuring costs, excluding asset impairments, were
recognized as liabilities at the time management committed to the plan.
Management determined that these costs provided no future economic benefit,
they were incremental to other costs incurred by the Company prior to the
restructuring, or were contractual obligations that existed prior to the date
the plan was approved and were either continued after the exit plan was
completed with no economic benefit to the Company or could not be cancelled
without penalty; and they were incurred as a direct result of the plan to
exit the identified activities. The asset impairments were accounted for in
accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of. The Company recorded a
charge of approximately $110.3 million related to employee termination
benefits, facility closure costs, asset disposals and other exit costs. The following table shows a reconciliation of the beginning and ending
restructuring liability balances from inception through November 30, 2004
related to all restructuring activities recorded by the Company under the
2001 Plan. During the fiscal quarter ended November 30, 2004, cash payments
were made related to the monthly lease obligations for lease abandonments
leaving an outstanding liability of $3.1 million as of November 30, 2004. Property,
    
    
    
    
    
    EmployeeLease
    
    plant, and
    
    Other exit
    
    termination
    
    Goodwill andabandonments
    
    equipment
    
    costs
    
    benefits
    
    Intangibles
    
    Total(In thousands)Balance at August 31, 2000
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Plan charges
    
    
    9,404
    
    
    
    26,915
    
    
    
    3,528
    
    
    
    727
    
    
    
    69,704
    
    
    
    110,278Cash paid
    
    
    (683
    )
    
    
    
    
    
    
    
    
    
    
    (498
    )
    
    
    
    
    
    
    (1,181
    )Non-cash write downs
    
    
    
    
    
    
    (26,915
    )
    
    
    
    
    
    
    
    
    
    
    (69,704
    )
    
    
    (96,619
    )Balance at August 31, 2001
    
    $
    8,721
    
    
    $
    
    
    
    $
    3,528
    
    
    $
    229
    
    
    $
    
    
    
    $
    12,478Cash paid
    
    
    (1,625
    )
    
    
    
    
    
    
    (487
    )
    
    
    (229
    )
    
    
    
    
    
    
    (2,341
    )Other adjustments
    
    
    538
    
    
    
    
    
    
    
    (1,862
    )
    
    
    
    
    
    
    
    
    
    
    (1,324
    )Balance at August 31, 2002
    
    $
    7,634
    
    
    $
    
    
    
    $
    1,179
    
    
    $
    
    
    
    $
    
    
    
    $
    8,813Cash paid
    
    
    (1,701
    )
    
    
    
    
    
    
    (199
    )
    
    
    
    
    
    
    
    
    
    
    (1,900
    )Other adjustments
    
    
    (297
    )
    
    
    
    
    
    
    (980
    )
    
    
    
    
    
    
    
    
    
    
    (1,277
    )Balance at August 31, 2003
    
    $
    5,636
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    5,636Cash paid
    
    
    (2,192
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,192
    )Other adjustments
    
    
    178
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    178Balance at August 31, 2004
    
    $
    3,622
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    3,622Cash paid
    
    
    (513
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (513
    )Balance at November 30, 2004
    
    $
    3,109
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    3,109
 7




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Interland, Inc.
Notes To Consolidated Financial Statements(Continued) 2003 Plan During 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. One-time
termination benefits for employees required to render services until they are
terminated in order to receive termination benefits were recognized ratably
over the future service period. The plan provided for the closure of three
data center facilities, a reduction of related workforce of approximately 171
employees, and the termination of bandwidth and data connectivity contracts
in place at these and other facilities. The 2003 Plan charges consisted of
$2.1 million in lease termination costs, $1.9 million in bandwidth
termination costs, $1.3 million in employee termination benefits, and $1.3 in
fixed asset related charges. These charges were partially offset by $0.2
million of various adjustments, including the settlement of certain data
connectivity contract obligations for amounts less than the original
estimates. There was also a charge for $0.9 million to property, plant and
equipment representing the write down of remaining book value of fixed assets
originally written down to their estimated salvage value included in the
restructuring charge recorded in the 2003 Plan charges. The following table shows a reconciliation of the beginning and ending
liability balances from inception through November 30, 2004 related to all
restructuring activities recorded by the Company under the 2003 Plan. The
$0.5 million balance at November 30, 2004 represents the remaining bandwidth
termination liabilities, which the Company expects to have final resolution
during fiscal year 2005. Property,
    
    
    
    
    
    EmployeeLease
    
    plant, and
    
    Other exit
    
    terminationabandonments
    
    equipment
    
    costs
    
    benefits
    
    Total(In thousands)Balance at August 31, 2002
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Plan charges
    
    
    2,061
    
    
    
    1,317
    
    
    
    1,886
    
    
    
    1,317
    
    
    
    6,581Cash paid
    
    
    (2,130
    )
    
    
    (227
    )
    
    
    (426
    )
    
    
    (1,165
    )
    
    
    (3,948
    )Other adjustments
    
    
    79
    
    
    
    46
    
    
    
    (236
    )
    
    
    (121
    )
    
    
    (232
    )Non-cash write down
    
    
    
    
    
    
    (871
    )
    
    
    
    
    
    
    
    
    
    
    (871
    )Balance at August 31, 2003
    
    $
    10
    
    
    $
    265
    
    
    $
    1,224
    
    
    $
    31
    
    
    $
    1,530Cash paid
    
    
    (6
    )
    
    
    (236
    )
    
    
    (227
    )
    
    
    (31
    )
    
    
    (500
    )Other adjustments
    
    
    (4
    )
    
    
    (29
    )
    
    
    (453
    )
    
    
    
    
    
    
    (486
    )Balance at August 31, 2004
    
    $
    
    
    
    $
    
    
    
    $
    544
    
    
    $
    
    
    
    $
    544Cash paid
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Other adjustments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance at November 30, 2004
    
    $
    
    
    
    $
    
    
    
    $
    544
    
    
    $
    
    
    
    $
    544
 2004 Plan In 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. These restructuring charges include $0.3 million for lease
commitments and $0.8 million for employee severance and benefits expense. The following table shows a reconciliation of the beginning and ending
liability balances from inception through November 30, 2004 related to all
restructuring activities recorded by the Company under the 2004 Plan. During
the fiscal quarter ended November 30, 2004, cash payments were made related
to the monthly lease obligations that have a remaining liability of $0.1
million to be paid out by April 2005, and the final employee termination
payments. 8




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Interland, Inc.
Notes To Consolidated Financial Statements(Continued) EmployeeLease
    
    terminationabandonments
    
    benefits
    
    Total(In thousands)Balance at August 31, 2003
    
    $
    
    
    
    $
    
    
    
    $
    Plan charges
    
    
    279
    
    
    
    785
    
    
    
    1,064Cash paid
    
    
    (72
    )
    
    
    (765
    )
    
    
    (837
    )Balance at August 31, 2004
    
    $
    207
    
    
    $
    20
    
    
    $
    227Cash paid
    
    
    (64
    )
    
    
    (20
    )
    
    
    (84
    )Balance at November 30, 2004
    
    $
    143
    
    
    $
    
    
    
    $
    143
  4.
    
    Purchase Business Combination Liabilities In 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
Business Combination. 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
November 30, 2004: (in thousands)LeaseAbandonment
    
    TotalBalance at August 31, 2004
    
    $
    740
    
    
    $
    740Net Cash Paid
    
    
    (43
    )
    
    
    (43
    )Balance at November 30, 2004
    
    $
    697
    
    
    $
    697
 During the fiscal quarter ended November 30, 2004, 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.  5.
    
    Other Liabilities In 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 by $0.8 million. The sales tax
reserve of $1.2 million at August 31, 2004 was reduced to $0.4 million at
November 30, 2004 to record this change in estimate. The Company has
recognized this gain through discontinued operations during the quarter ended
November 30, 2004. The Company continues to be a party to numerous sales and use tax assessments
and audits related to the discontinued operations and have an established
reserve of $0.4 million and $1.2 million as of November 30, 2004 and August
31, 2004, respectively. The Company has also established an accrual for
income tax liabilities of $1.5 million and $1.6 million as of November 30,
2004 and August 31, 2004, respectively.  6.
    
    Discontinued Operations 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 9




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Interland, Inc.
Notes To Consolidated Financial Statements(Continued) 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 quarter 2005, the Company recognized a gain
of $0.6 million from discontinued operations. This gain consisted of a
reduction to a previously recorded sale reserve by $0.8 million, offset by
$0.2 million of required legal fees in defense and settlement of Micron PC
legal matters. The Company has a sales and use tax assessments and audit
reserve of $0.5 million, $0.7 million in contingent liabilities, $0.2 million
in legal expenses and $0.3 for other liabilities related to the disposal of
discontinued operations as of November 30, 2004.  7.
    
    Contingencies 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 above. 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. 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 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 10




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Interland, Inc.
Notes To Consolidated Financial Statements(Continued) 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. 11




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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 the recent acquisitions. Factors that could cause actual results
to differ materially from expected results are identified in Risk Factors
below, and in the Companys annual report on 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 November 30, 2004, or November 30, 2003, unless otherwise
indicated. All annual references are also on a fiscal August 31st year-end
basis, unless otherwise indicated. All tabular dollar amounts are stated in
thousands. Overview Interland 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 an 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. Interland offers to provide website marketing, design and management, as well
as management of hosted application services through both its shared and
dedicated lines of business. (The shared line of business provides services to
customers whose needs are compatible with being hosted on a server that hosts
hundreds of other similar customers; the dedicated line of business serves
customers who require a server or servers exclusively devoted to their needs.)
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. Interlands products are sold directly and through distribution partners, for
both shared and dedicated hosting business lines. Interland 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 line of business 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. Interland has acquired and developed proprietary software for the efficient
integration, packaging and support of new technologies and services into its
basic hosting products. The software or technology may be developed by the
Company, acquired, or licensed from third parties. The Companys web design
products are largely derived from, or influenced by software and related
technology obtained through the acquisition of Trellix Corporation in early
2003. 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 12




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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, collectively
known as Business Solutions, designed to help mainstream businesses attract
and serve customers through websites supplied by Interland designers using its
proprietary design software. During 2003, the Company tested and marketed
products based on the use of these software tools. Based on initial results,
the Company, in several stages, increased the number of direct salespeople, web
designers and support personnel dedicated to this effort in order to further
test the ability of the distribution and provisioning models to perform
profitably at increasingly larger scales. At the end of February 2004, however, management concluded that despite the
fact that many of the assumptions underlying the business plan were being
proven, certain aspects of the business were not performing to the standard
required to justify continued high levels of investment. Accordingly, in early
March 2004 the Company announced that it would substantially reduce its
investment level and concentrate the website and software development teams in
Atlanta for greater interaction with the rest of the Company. At the same
time, the Company recognized that the costs of acquiring customers through a
directly-employed sales force would substantially retard market penetration and
accordingly shifted its customer acquisition efforts to an indirect sales
model. Interlands distribution partners enable it 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. 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 quarter 2005, the Company recognized a gain
of $0.6 million from discontinued operations. This gain consisted of a
reduction to a previously recorded sale reserve by $0.8 million, offset by
$0.2 million of required legal fees in defense and settlement of Micron PC
legal matters. The Company has a sales and use tax assessments and audit
reserve of $0.5 million, $0.7 million in contingent liabilities, $0.2 million
in legal expenses and $0.3 for other liabilities related to the disposal of
discontinued operations as of November 30, 2004. 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 Quarters Ended November 30, 2004 And 2003 The loss from continuing operations decreased $4.2 million, or 52.4% to $3.8
million for the quarter ended November 30, 2004 from $8.0 million for the
quarter ended November 30, 2003. The basic and diluted loss per share
decreased $0.25 per share, or 51.0% for the quarter ended November 30, 2004
when compared to the same period of the prior fiscal year. Revenues Total revenues decreased $3.6 million, or 13.6%, to $23.1 million for the
quarter ended November 30, 2004 from $26.7 million for the quarter ended
November 30, 2003. For the quarter endedNovember 30,
    
    November 30,2004
    
    2003in thousandsHosting revenue
    
    $
    21,910
    
    
    $
    25,289Other revenue
    
    
    1,151
    
    
    
    1,398Total revenue
    
    $
    23,061
    
    
    $
    26,687
 Hosting revenues decreased $3.3 million, or 13.1% to $21.9 for the quarter
ended November 30, 2004 from $25.3 million for the quarter ended November 30,
2003. 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. Although the
Company intends to stabilize the revenue of its acquired Web hosting business
by focusing on improving customer retention and increasing sales of hosting
services, management believes that the mainstream market will be the primary
source of future growth. Other revenues decreased $0.2 million or 1.8% to 1.2 million for the
quarter ended November 30, 2004 from $1.4 million for the quarter
ended November 30, 2004. The decrease is primarily related to lower
co-location revenues. Other revenues are primarily comprised of
consulting, bandwidth transfer coverage billings, Internet
connectivity fees, and co-location services. 13




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As of November 30, 2004, the Company had approximately 173,000 paid shared
hosting customer accounts and continues to manage approximately 9,200 dedicated
servers, many of which host multiple web sites, compared to approximately
196,000 paid shared hosting customer accounts and nearly 9,200 dedicated
servers as of November 30, 2003. 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 operations until they can be re-utilized by a
new customer. The Companys revenues are highly correlated with the net change in the total
of the monthly recurring charges associated with all 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. During the first quarter of fiscal year 2005 the MRC of the Companys Shared
line of business declined from $4,353,000 at August 31, 2004 to $4,137,000 at
November 30, 2004, or 5.0%. MRC Churn (MRC of terminating customers as a
percentage of beginning MRC) averaged 2.5% per month during the quarter ended
November 30, 2004 compared to an average of 2.8% during the quarter ended
August 31, 2004. The Company believes that this improvement in churn reflects
the Companys investments in improving reliability and customer service that
has also led to improved customer satisfaction as measured by surveys. Sales
produced New Shared MRC, which averaged $66,000 per month for the quarter ended
November 30, 2004, resulting in an average negative Net MRC Change of $48,000
per month during the same quarter compared to sales producing New Shared MRC,
which averaged $67,000 per month for the quarter ended August 31, 2004,
resulting in an average negative Net MRC Change of $68,000 per month during the
same quarter. 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 first quarter of fiscal year 2005 the MRC of the Companys Dedicated
line of business declined from $2,998,000 at August 31, 2004 to $2,927,000 at
November 30, 2004, or 2.4%. MRC Churn averaged 3.7% during the quarter ended
November 30, 2004 compared to an average of 4.6% during the quarter ended
August 31, 2004. New Dedicated sales averaged $101,000 per month for the
quarter ended November 30, 2004, resulting in an average negative Net MRC
Change of $29,000 per month during the same quarter compared to sales producing
New Dedicated MRC, which averaged $101,000 per month for the quarter ended
August 31, 2004, resulting in an average negative Net MRC Change of $47,000 per
month during the same quarter. The Dedicated line of business 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 from $115,000
during the previous fiscal quarter to $77,000 during the quarter ended November
30, 2004, an improvement of 33.0% 14




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Operating Costs And Expenses Network Operating Costs Network operating costs decreased 19.9% to $5.7 million for the quarter ended
November 30, 2004 from $7.1 million in the same period of the prior year. The
decrease in network operating costs is most directly related 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
$0.5 million reduction in bandwidth connectivity costs, a $0.1 million
reduction in maintenance contract costs, and a $0.6 million reduction in labor
costs. In addition the Company reduced operating lease costs by $0.1 million
as a result of purchasing the underlying leased equipment. Sales and Marketing Sales and marketing expenses decreased 23.8% to $4.0 million for the quarter
ended November 30, 2004 from $5.2 million in the same period of the prior year.
This decrease in sales and marketing expenses is primarily due to the
elimination of additional marketing expenditures related to the direct
mainstream market initiative of $0.2 million and additional commissions,
salaries and benefits of $0.9 million during the quarter ended November 30,
2003 that were eliminated when the Company publicly announced it would be
substantially reducing its investment in direct marketing and sales initiatives
in March 2004. Technical Support Technical
support expenses decreased 20.6% to $3.8 million for the quarter
ended November 30, 2004 and $4.8 million in the same period
of the prior year. The Company 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 $0.7 million decrease in
contract labor and consultants and a $0.3 million decrease in
salaries and benefits. General and Administrative General and administrative expenses decreased 12.2% to $7.1 million for the
quarter ended November 30, 2004 from $8.1 million in the same period of the
prior year. The primary factor causing the decrease in general and
administrative expenses in the first quarter of fiscal 2005 was a $2.0 million
decrease in salaries and benefits associated with the reduction of headcount
compared to prior year. Partially offsetting this decrease were increases in
legal expense of $0.4 million and a $0.6 million increase in professional fees
primarily related to Sarbanes-Oxley certification contractors and consultants. Bad Debt Expense Bad debt expense decreased $0.7 million, or 61.1%, to $0.4 million for the
quarter ended November 30, 2004 from $1.1 million in the same period of the
prior year. 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. Depreciation and Amortization Depreciation and amortization expenses decreased 28.2% to $5.9 million for the
quarter ended November 30, 2004 from $8.2 million in the same period of the
prior year. The amortization expense decreased due to the impairment
adjustments made to the Companys intangible assets in May 2004. The decrease
in depreciation expense is a result of the continued decline in capital
expenditures and the expiration of leases during the fiscal year 2004 used to
purchase capital equipment. Interest Income (Expense), net 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 net expense of $0.1 during the quarter ended November 30, 2003
went to a $41,000 net income for the quarter ended November 30, 2004 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 ended
November 30, 2004. 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 15




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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 endedNovember 30,
    
    November 30,2004
    
    2003in thousandsNet loss
    
    $
    (3,196
    )
    
    $
    (8,553
    )Depreciation and amortization
    
    
    5,877
    
    
    
    8,182Interest expense (income)
    
    
    (41
    )
    
    
    138Discontinued operations
    
    
    (601
    )
    
    
    582EBITDA from continuing operations
    
    $
    2,039
    
    
    $
    349Interest income/(expense)
    
    
    41
    
    
    
    (138
    )Provision for bad debts
    
    
    440
    
    
    
    1,131Gain on the sale of assets
    
    
    (13
    )
    
    
    (22
    )Other non-cash adjustments
    
    
    158
    
    
    
    173Changes in assets and liabilities:Receivables, net
    
    
    (490
    )
    
    
    (598
    )Other current assets
    
    
    301
    
    
    
    364Accounts payable, accrued expenses, and deferred revenue
    
    
    (2,583
    )
    
    
    (3,459
    )Net cash used in operating activities
    
    $
    (107
    )
    
    $
    (2,200
    )
 For the quarter ended November 30, 2004, the Companys EBITDA increased $1.7
million to $2.0 million as compared to $0.3 million in the same period of the
prior year. This increase is 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 November 30, 2004, the Company had $23.2 million in cash and cash
equivalents, $3.0 million in short-term unrestricted investments and $10.3
million in short- and long-term restricted investments representing a total
cash and investment position of $36.5 million. This represents a decrease of
$2.1 million or 5.4% decrease from the total cash and investment position of
$38.6 million at August 31, 2004. On a comparative basis cash used in operating activities of continuing
operations decreased $2.1 million or 95.1% to $0.1 million for the quarter
ended November 30, 2004 versus the $2.2 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
(used in) provided by investing activities decreased $9.4 million to ($0.8)
million used for the three months ended November 30, 2004 versus $8.6 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 $2.5 million or
73.2% to $0.9 million for the quarter ended November 30, 2004 versus the $3.5
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 $0.4 million or 64% to $0.2 million for the
quarter ended November 30, 2004 versus the $0.6 million of cash used to fund
discontinued operations during the same period of the prior year. The primary
reason for the decrease in 16




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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 November 30,
2004, the principal balance on the promissory note was $4.0 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 November 30, 2004, the amount of collateral is $4.3 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 fiscal quarter of 2005, the Company spent $0.8 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 plans to reduce its level of cash requirements
through a decrease in capital purchases and by improving sales and reducing
churn. The Company also will have reduced cash outlays for payments associated
with prior integration and discontinued operation liabilities and will have
reduced debt payments because of the buyout of capital lease obligations during
2004. The Company expects to continue to have negative cash flows for at least
the next three quarters as it continues to execute on its business plan. There
can be no assurance that Interlands continuing efforts to stabilize or
increase its revenue will be successful and 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. Risk Factors You should carefully consider the following factors and all other information
contained in this Form 10-Q and the Companys recently filed 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 first quarter of fiscal
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; and
    
    Improving network security features. To the extent that increases in expenses are not offset by increases in
revenues, operating losses will increase. 17




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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. Unfavorable results of existing litigation may cause Interland to have
additional expenses or operating losses that could exceed the Companys ability
to pay. The Company is defending a number of matters in active litigation (See Item 3,
Legal Proceedings). The cost of defending lawsuits, regardless of their
merit, can be substantial. The Company spent $3.0 million during 2004 to
defend lawsuits. Although the Company has favorably resolved a number of
lawsuits through rulings, verdicts, and minimal settlements, and although the
Company may be successful in defending ongoing litigation, the costs of defense
cannot be expected to be avoided. The Company believes it has appropriately
established reserves for the contingency of adverse verdicts. In order for a
loss contingency to be reserved for in the financial statements, GAAP requires
that the information available prior to issuance of the financial statements
indicates that it is probable that an asset had been impaired or a liability
had been incurred at the date of the financial statements, it is implicit in
this condition that it must be probable that one or more future events will
occur confirming the fact of the loss and the amount of loss can be reasonably
estimated. Therefore, the Company has not reserved for all of its pending
lawsuits. Consequently lawsuits for which there is no reserve nonetheless pose
a risk of substantial loss which would have a material effect on the Companys
financial position. Additionally, even in those cases where a reserve has been
established, the amount of the reserve is necessarily an estimate and the
actual result may differ materially. Reserves are established only for the
damages that may be assessed, and do not take into account the costs of
litigation. Even in those instances where Interland may ultimately prevail on
appeal, an adverse verdict in a substantial amount may damage the reputation of
the Company, may require the Company to post an appeal bond in an amount which
deprives the Company of cash, and require additional expenditures for the cost
of appeal. The outcome of litigation is unpredictable, and an adverse final
verdict could exceed the Companys ability to pay. 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, 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. 18




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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 its 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:  
    
    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; 19




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
    
    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 November 30, 2004 the high and low closing price for
Interland common stock on NASDAQ was $7.36 and $2.67, respectively. Interland operates in a new and evolving market with uncertain prospects for
growth and may not be able to generate 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:  
    
    Increased expenditures on sales and marketing programs to replace
failing customers;
    
    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. 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 20




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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 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 21




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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 measures that it
implements. The costs required to eliminate computer viruses and alleviate
other security problems could 22




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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 23




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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. 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 November 30,
2004, approximately 98% of the Companys liquid investments mature within three
months and 2% mature within one year. As of November 30, 2004, 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 commercial paper rated A1/P1, bank certificates rated AA or
better, and corporate medium-term notes rated AA or better. At November 30,
2004, the Companys investment portfolio included fixed rate securities with an
estimated fair value of $31.0 million. 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 November 30, 2004 was $4.8 million. 
 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 November 30, 2004.
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. Nevertheless, the Companys management, including its chief executive officer,
chief financial officer and chief accounting officer, do not expect that the
Companys disclosure controls and procedures will prevent all error and all
fraud. A control system, no matter how well conceived and operated, can provide
only reasonable, not absolute, assurance that the objectives of the control
system are met. The design of any system of controls is based in part upon
certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions. Further, the design of a control system must
reflect the fact that there are resource constraints, and the benefits of
controls must be considered relative to their costs. Because of the inherent
limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within the Company have been detected. These inherent limitations include the
realities that judgments in decision-making can be faulty, and that breakdown
can occur because of simple error or mistake. In particular, many of the
Companys current processes rely upon manual reviews and processes to ensure
that neither human error nor system weakness has resulted in erroneous
reporting of financial data. The Company considers a change in its internal control over financial reporting
to be material only when the failure to effectuate such change would have been
expected to result in a substantial likelihood of a material misstatement of
the Companys financial statements. While we continued to make incremental
improvements to our internal controls over 24




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financial reporting during the fiscal quarter, there were no changes in the
Companys internal control over financial reporting which management considered
to be material. 25




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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
above. 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. 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 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 26




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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. 
 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
August 6, 2001) (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.
 27




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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: December 27, 2004
    /s/ Allen L. ShulmanAllen L. ShulmanSenior Vice President, Chief Financial Officer,
and Executive Counsel
(Principal Financial Officer) 28