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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K

|           |  |                                                                                                                                          
|---------- |  | -----------------------------------------------------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                                                                          
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934                                                     
|           |  | For the year ended December 31, 2001                                                                                                     
|           |  | OR                                                                                                                                       
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from                to

Commission File Number: 000-28467

Z-TEL TECHNOLOGIES, INC.(Exact name of Registrant as specified in its charter)

|                                |  |                       
|------------------------------- |  | ----------------------
|Delaware                        |  | 59-3501119            
|(State or other jurisdiction of |  | (I.R.S. Employer      
|incorporation or organization)  |  | Identification Number)

601 South Harbour Island Boulevard, Suite 220
Tampa, Florida 33602
(813) 273-6261(Address, including zip code, and
telephone number including area code, of
Registrants principal executive offices)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common
Stock, par value $.01 per share, preferred stock purchase rights

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.

Yes þ No o


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

The aggregate market value of the Registrants Common Stock held by
non-affiliates of the Registrant on March 26, 2002 (assuming solely for these
purposes that only directors, executive officers and beneficial owners of
greater than 10% of the Registrants Common Stock are affiliates), based on the
closing price of the Common Stock on the Nasdaq National Market as of such
date, was approximately $57,908,747.

The number of shares of the Registrants Common Stock outstanding as of
March 26, 2002 was approximately 35,020,305.

DOCUMENTS INCORPORATED BY
REFERENCE

Portions of the
registrant's proxy statement relating to its 2002 Annual Meeting of
Stockholders, to be filed subsequently, are incorporated by reference
into Part III of this Report.



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TABLE OF CONTENTS



|                                               |                                                                                                |  |  |  |  |  |  | 
|---------------------------------------------- | ---------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I                                        
|                                               | Item 1. Business                                                                              
|                                               | Item 2. Properties                                                                            
|                                               | Item 3. Legal Proceedings                                                                     
|                                               | Item 4. Submission of Matters to a Vote of Securities Holders                                 
|PART II                                       
|                                               | Item 5. Market for Registrants Common Equity and Related Stockholder Matters                 
|                                               | Item 6. Selected Consolidated Financial Data                                                  
|                                               | Item 7. Managements Discussion and Analysis of Financial Condition and Results Of Operations.
|                                               | Item 7a. Quantitative and Qualitative Disclosures about Market Risk                           
|                                               | Item 8. Financial Statements and Supplementary Data                                           
|Item 8. SIGNATURES                            
|June 30, 2001 Stock & Asset Purchase Agreement
|List of Subsidiaries                          
|PriceWaterhouseCoopers Consent                



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TABLE OF CONTENTS

|           |  |                                                                                       |  |    
|---------- |  | ------------------------------------------------------------------------------------- |  | ---
|PART I.    |  |                                                                                       |  |    
|           |  |                                                                                       |  |    
|Item 1.    |  | Business                                                                              |  | 1  
|           |  |                                                                                       |  |    
|Item 2.    |  | Properties                                                                            |  | 20 
|           |  |                                                                                       |  |    
|Item 3.    |  | Legal Proceedings                                                                     |  | 20 
|           |  |                                                                                       |  |    
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                   |  | 21 
|           |  |                                                                                       |  |    
|PART II.   |  |                                                                                       |  |    
|           |  |                                                                                       |  |    
|Item 5.    |  | Market for the Registrants Common Equity and Related Stockholder Matters             |  | 21 
|           |  |                                                                                       |  |    
|Item 6.    |  | Selected Consolidated Financial Data                                                  |  | 22 
|           |  |                                                                                       |  |    
|Item 7.    |  | Managements Discussion and Analysis of Financial Condition and Results
of Operations |  | 24 
|           |  |                                                                                       |  |    
|Item 7A    |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 45 
|           |  |                                                                                       |  |    
|Item 8.    |  | Financial Statements and Supplementary Data                                           |  | F-1
|           |  |                                                                                       |  |    
|Item 9.    |  | Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure  |  | 46 
|           |  |                                                                                       |  |    
|PART III.  |  |                                                                                       |  |    
|           |  |                                                                                       |  |    
|Item 10.   |  | Directors and Executive Officers of the Registrant                                    |  | 46 
|           |  |                                                                                       |  |    
|Item 11.   |  | Executive Compensation                                                                |  | 46 
|           |  |                                                                                       |  |    
|Item 12.   |  | Security Ownership of Certain Beneficial Owners and Management                        |  | 46 
|           |  |                                                                                       |  |    
|Item 13.   |  | Certain Relationships and Related Transactions                                        |  | 46 
|           |  |                                                                                       |  |    
|PART IV.   |  |                                                                                       |  |    
|           |  |                                                                                       |  |    
|Item 14.   |  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                      |  | 46 
|           |  |                                                                                       |  |    
|Signatures |  |                                                                                       |  | 50 





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PART I




Item 1. Business

General

Z-Tel Technologies, Inc. was incorporated under the laws of Delaware in
1998. We are a provider of advanced, integrated communications services
primarily to residential customers. We offer local and long distance telephone
services in combination with enhanced communications features accessible
through the telephone, the Internet and certain personal digital assistants.
Through our uniquely designed web interface, our subscribers are able to manage
their communications through the power of the Internet and the visual, point
and click functionality of the personal computer. Our services are designed to
make communications easier and more efficient.

Our business strategy takes advantage of statutory and regulatory changes
that enable us to gain access to the individual components of the traditional
local telephone service providers (incumbent local exchange carrier or
ILEC) networks, referred to as the unbundled network element platform. The
Federal Communications Commission (the FCC) has mandated that the incumbent
local exchange carriers provide competing local telephone companies such as us
with the unbundled network element platform components at prices based on a
forward-looking, total long-run incremental cost methodology. Access to these
components, in combination with our proprietary technology and advanced
communications network, enables us to provide cost-effective local and long
distance telephone services with enhanced features.

We currently offer our Z-LineHOME service, which is our primary service
offering, in thirty-eight states in areas served by the Regional Bell Operating
Companies (the Bell operating companies). Within these markets, we believe
that we are one of few competitive local exchange carriers specifically
targeting the needs of residential customers. It is our intent to expand
service into additional states as pricing and implementation rules for the
unbundled network element platform become acceptable for market entry into
those states.

Our other retail service offerings are Touch 1 Long Distance and
Z-LineBUSINESS. Z-LineBUSINESS is currently in a betatest phase. We also
recently launched a wholesale services initiative whereby we intend to offer
our services to other carriers for resale to their retail customers. Each of
our service offerings except for Touch 1 Long Distance are built around an
enhanced service offering we call Z-Line. A Z-Line includes multiple
proprietary features that combine the convenience of the telephone with the
power of the Internet (Z-Line Features). Accessible by telephone or the
Internet, at www.myzline.com or www.z-tel.com, Z-Line Features enable our
customers to direct, retrieve, deliver, compile and otherwise manage their
voice communications.

Industry Background

The Telecommunications Act of 1996 (the Telecommunications Act) was
passed principally to foster competition in the local telecommunications
markets. The Telecommunications Act imposes a variety of duties upon the
incumbent local exchange carriers, including the duty to provide other
communications companies, like us, with access to their network elements on an
unbundled basis at any feasible point. Such access must be at rates and on
terms and conditions that are just, reasonable and nondiscriminatory. A network
element is a facility or piece of equipment of the local telephone companys
network or the features, functions or capabilities such facility or equipment
provides. The Telecommunications Act also establishes procedures under which
the Bell operating companies will be allowed to handle long distance calls
originating from within their telephone service area and terminating outside
their area. The Bell operating companies were divested by AT&T in 1984 pursuant
to court order under which they were prohibited from providing in-region long
distance telephone service. With the passage of the Telecommunications Act, a
Bell operating company can provide such in-region service if it demonstrates to
the FCC and state regulatory agencies that it has complied with a 14-point
regulatory checklist, including offering interconnection to other
communications companies and providing access to its unbundled network elements
on terms approved by a state public service commission.

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On November 5, 1999, the FCC released an order establishing the list of
unbundled network elements that incumbent local exchange carriers nationwide
must provide. Taken together, these unbundled network elements comprise the
essential facilities, features, functions and capabilities of an incumbent
local exchange carriers network. Under the FCCs order, the incumbent local
exchange carriers must allow competing local telephone companies such as us to
use the unbundled network elements, in an individual or combined fashion, to
provide basic local telephone service and must price the elements using a
forward-looking, total long-run incremental cost methodology. We expect both
individual network components and components in combined component service
packages to be available at attractive prices nationwide as state regulatory
authorities and incumbent local exchange carriers conform to the recent FCC
mandates. Pricing and implementation rules for unbundled network elements in
combined service packages or platform offerings that are at least acceptable
for market entry have been adopted in multiple states. The prices for the use
of individual network components and combined component service packages will
nevertheless vary from state to state, as will an individual states oversight
of unbundled network element platform implementation and operation in regard to
individual unbundled network elements and elements provided in combinations.
As discussed below, the FCC is currently re-examining the availability of
unbundled network elements as part of a scheduled triennial review of those
regulations.

Business Overview

By integrating the simplicity of standard telephone service with the
robust features that our Internet applications deliver, we have created an
environment for managing communications that is accessible by the telephone or
personal computer. That environment includes the following elements:

Cost-Effective Bundled Local and Long Distance Telephone Service.We
provide a cost-effective bundled package of local and long distance telephone
services, which includes all the enhanced features of Z-Line Features as well
as enhanced telephone services such as call waiting and caller identification,
in markets that have favorable regulatory environments for residential
competition. We have typically leased facilities of the existing incumbent
local exchange carrier on a forward-looking, long-term incremental cost basis,
which enables us to avoid the need to invest significant capital into telephone
plant and equipment. As a result, we are able to provide a competitively
priced, bundled package that includes local and long distance telephone
services and enhanced services without significant up-front expense.

Scalable Platform for New Markets.The unbundling of network elements
allows us to access the incumbent local exchange carriers facilities to
provision our service to our customers. As a result, we have the ability to
enter new markets quickly, and without a significant investment in equipment,
as regulatory authorities in those markets adopt favorable rules and pricing
for unbundled network elements. Using Z-Line Features, customers can manage and
configure their own enhanced calling features, thus minimizing our need for an
expanded customer service infrastructure.

Seamless Integration of Personal Organizational Tools.The features
available in our Z-Line Features have been designed to allow users to download
their personal directories from a variety of software packages, including
Microsoft Outlook. In addition, directories from other personal contact
managers can be downloaded into Outlook and then downloaded into Z-Line
Features. Once this information has been downloaded, customers can use their
database of contacts to create easily sub-directories for special group
messaging. By utilizing Z-Line Features, customers can, with the click of a
mouse, initiate calls or forward messages to contacts that have been stored in
their personal directories.

Advanced Proprietary Technology.We have created an integrated and
proprietary software and advanced network architecture that enables the
enhanced features of our service. We have created software applications that
can control the basic functions of initiating and completing a telephone call
regardless of the access device, such as a telephone, personal computer or
personal digital assistant. These applications allow our customers to control
simultaneously all the basic functions of a telephone call using such device.
We are also in the process of developing and enhancing our customer care,
billing and provisioning software into one seamlessly integrated package.

Our network architecture is designed to interconnect our main enterprise
management center in Tampa with the switching architecture of the incumbent
local exchange carrier. This allows us to provide telecommunications services
without the need to collocate network equipment in the central offices of the
incumbent local exchange

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carrier in our target markets and enhances our ability to enter new markets
quickly and cost effectively. Our network architecture also is designed to
accommodate a number of developing technologies, such as telephone calls over
Internet protocol, digital subscriber line, asynchronous transfer mode, and
coaxial cable systems as these technologies gain mainstream acceptance.

We continue to pursue Z-LineHOME marketing and distribution in new states
as state regulatory authorities adopt favorable pricing, implementation rules
and acceptable operations support systems performance for the unbundled network
element platform components. As acceptable pricing and operations support
systems become available, we intend to move toward potential market entry into
Bell operating company territories in each state. Our Z-LineBUSINESS offering
is in a betatest phase. We intend eventually to offer Z-LineBUSINESS in the
same territories in which we offer Z-LineHOME. We plan also to offer
Z-Line-based services on a wholesale basis to other carriers in each such
territory.

SERVICES

Z-LineHOME

Z-LineHOME is our principal service offering and is currently being
offered in Alabama, Arizona, California, Colorado, Delaware, Florida, Georgia,
Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maryland, Massachusetts,
Michigan, Minnesota, Mississippi, Missouri, Montana, New Mexico, New York, North Carolina, North
Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina,
Tennessee, Texas, Utah, Vermont, Virginia, Washington, West Virginia, and
Wisconsin, in most areas served by the Bell operating company operating in
those states. Z-LineHOME is local residential telephone service (using a
customers existing telephone number) bundled with long distance (1+) telephone
service, calling card services, our Z-Line Features and additional enhanced
features, which may include caller identification, call forwarding, three-way
calling, call waiting and speed calling. We also offer Member-to-Member long
distance calling. For a small monthly fee, Z-LineHOME subscribers may make
unlimited long distance calls to other Z-LineHOME subscribers without toll
charges.

We intend to offer Z-LineHOME in additional states as soon as favorable
pricing and implementation rules are adopted in those states. We are also
developing other bundled combinations of our services at varied price points in
order to stimulate and expand customer interest in our services. For example,
we have begun to offer in several states a lower priced version of Z-LineHOME
that includes fewer bundled long distance minutes and features. Additional long
distance minutes and features are being offered separately for an additional
monthly price. We are evaluating the elimination of the monthly
Member-to-Member fee in connection with our standard Z-LineHOME offering.

Z-LineBUSINESS

Z-LineBUSINESS is our complement service to Z-LineHOME targeted to small
businesses typically having four lines or fewer. Z-LineBUSINESS is local
telephone service (using a customers existing telephone number) bundled with
long distance (1+) telephone service, calling card services, our Z-Line
Features and additional enhanced features, which may include caller
identification, call forwarding, three-way calling, call waiting and speed
calling. We currently provide Z-LineBUSINESS on a limited test basis in
Illinois. We are not only testing the market for Z-LineBUSINESS, but also
testing and finalizing our operational interfaces, ordering processes, and
billing arrangements. We plan to begin rolling out the service from state to
state beginning in the third quarter of 2002 and eventually to offer it in
every territory where we offer Z-LineHOME.

Touch 1 Long Distance

Touch 1 Long Distance is a usage-based service that allows customers to
use us as their primary long distance calling provider to complete their
residential long distance (1+) calls. Touch 1 Long Distance is available
nationwide, although we are not actively marketing the service. We acquired
Touch 1 Communications, Inc. (Touch 1) in April 2000.

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Wholesale Services

We have begun an initiative to offer our Z-Line-based services on a
wholesale basis to other carriers for resale to their own retail customers. As
part of this initiative we might provide to other carriers, among other
services, local exchange telephone services, long distance telephone services,
Z-Line Features, enhanced features we acquire from the incumbent local
telephone company, provisioning (i.e. the process by which Z-Tel or another
telephone company is established as the end-users primary telephone company),
inbound sales, fulfillment, billing, collections and customer care. In most
cases we would expect the other carrier to utilize its own long distance
services in providing services to its customers. In some cases, in lieu of
providing services, we may license our Z-Line Features, provisioning or
operational systems technology to other carriers.

On March 20,
2002, we entered into a four-year contract with MCI WORLDCOM
Communications, Inc. (MCI) whereby we agreed to provide local exchange
services, Z-Line Features, operational and support services and licenses to use
certain of our proprietary technology, all for MCIs use in
providing telecommunications services to residential and small business customers. The contract
provides, among other things, that certain of our services will be provided at
direct cost; we will receive technology licensing fees and fees for usage of
our Z-Line platform, which provides the Z-Line Features; and MCI will share with us
gross profits it earns in providing certain Z-Line Features to its
customers. We paid MCI $2.3 million as a signing bonus, which MCI used
to purchase one million of our common shares. The contract caps total
software licensing fees at $50 million, but until that cap is reached, monthly
software licensing fees together with certain monthly per line fees for the use
of our technology are not to be less than $1.5 million, reduced
by any prepayments made before the contract. We expect to begin
providing these services on a test basis in April 2002.

Z-LINE FEATURES

Z-Line Features is the core feature set of all of our service offerings
except for Touch 1 Long Distance. It is a suite of features subscribers can
access via any telephone or via the Internet. Subscribers can retrieve,
forward, deliver, store, compile and otherwise manage their voice mail and
other communication needs. Using the Find-Me feature, subscribers can have
our system attempt to locate them at up to three numbers when they receive
incoming calls, and notify them via e-mail, pager or ICQ Internet Chat (instant
messaging) when a new voice mail message arrives. At our website, subscribers
can view a list of their voice mail messages and listen to them through their
computer speakers, deliver voice messages to groups of other subscribers, forward
voicemails and view historical billing statements. Subscribers also are
provided an e-mail address and the ability to receive faxes by e-mail.

We expect to provide additional functionality to Z-Line Features in the
future, including speech recognition capability, conference calling and the
ability to manipulate voicemail and other enhanced services settings from the
users desktop.

MARKETING AND DISTRIBUTION

We market our retail services to our customers through
independent sales representatives, strategic business partnerships, direct mail
and traditional advertising media such as billboards, radio and
television promoting recognition and awareness of
our Z brand. We also have entered into joint marketing or co-branding
arrangements with organizations that have large, well-established relationships
or customer bases in our target markets. We intend to continue to explore the
formation of alliances or ventures with other companies, including Internet
service providers, paging operators, cable television companies, utilities,
newspapers, financial institutions, retailers and credit card companies, which
we believe will allow us to penetrate efficiently large customer bases with a
relatively small capital outlay and to lower customer acquisition costs. We
also have an online sales channel, called ztelonline.com, that affords any
person the ability to send e-postcards to prospective Z-LineHOME subscribers
and earn compensation for those that open new accounts with us and become
active and billable customers.

BILLING AND COLLECTION

We have three primary methods for billing and collecting from our
customers. For our Z-LineHOME customers, we can (1) charge their credit card
account; (2) mail a bill to their address for payment by check or money order
or in person at certain payment locations proximate to the customer; or (3) set
up an automatic
withdrawal from their checking account. Currently, the majority of our
customers pay us by check or money order.

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OPERATIONS SUPPORT SYSTEMS AND CUSTOMER SUPPORT

We have invested substantially in our software platform, which includes
integrated customer ordering and provisioning, customer care and billing
functionality for our services. Z-Line Features allows our Z-LineHOME customers
to change their enhanced service feature configurations. A subscriber may also
update his or her enhanced service configurations via the telephone and, to a
limited extent, through selected personal digital assistants.

Z-LineHOME new service orders require us to interact with the applicable
incumbent local exchange carrier. Over the past two years, we improved our
operations support systems to include electronic gateways to the major
incumbent local exchange carriers, network element management software, and a
standard internal provisioning interface that can handle multiple incumbent
local exchange carrier ordering systems. This investment included outside
integration and consulting assistance. The electronic gateway allows us to
reduce the number of steps, and therefore the cost, required to provision a
customer and increase the accuracy of our provisioning process. Provisioning is
the process by which we establish ourselves as the customers primary local
exchange and long distance telephone service provider. We now have electronic
gateways operational in Alabama, California, Delaware, Florida, Georgia,
Illinois, Indiana, Kansas, Kentucky, Louisiana, Maryland, Massachusetts,
Michigan, Mississippi, Missouri, New York, North Carolina, Ohio, Oklahoma,
Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Vermont,
Virginia, West Virginia, and Wisconsin.

INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS

We have developed proprietary software that manages the integrated
features of our service offerings. Our software allows our network to interface
and interconnect with the systems of the incumbent local exchange carriers and
long-distance carriers. Our network communication facilities, which we call
Z-Nodes, are largely consolidated in our enterprise management center in
Tampa, Florida. This consolidation provides us the ability to maximize the
productivity and effective management of the platform.

We have entered into, and will continue to enter into, nondisclosure
agreements with our employees, independent contractors, business customers and
others. We believe these agreements will protect our confidential and
proprietary information, whether or not such information is copyrighted or
subject to trademark or patent protection. We intend to take all appropriate
legal action to protect our ownership and the confidentiality of all our
proprietary software, including, as appropriate, the filing of copyrights in
the U.S. Copyright Office.

Our intellectual property reflects the know-how, work product and
inventions of our research and development team, based at our technology center
in Atlanta, Georgia, who have substantial experience in computer technology,
telecommunications, web-based services, database management and integration,
and network development, architecture, operation and management.

For the fiscal years ended December 31, 2001, 2000, 1999 and 1998, we
invested approximately $12,800,000, $11,361,000, $8,356,000 and $4,728,000,
respectively, in company-sponsored research and development activities.

We have filed trademark applications for federal registration of more than
thirty trademarks with the United States Patent and Trademark Office, including
MEMBER TO MEMBER, Z-LINE HOME EDITION, Z-LINE ANYWHERE, CITY OF AMERICA,
Z-NODE, Z-LINE, Z-MAILBOX, Z-NUMBER, Z-NET, GENERATION Z, and MYZLINE. We have
received federal registration of the following trademarks: WEBDIAL, CLICK &
LISTEN, Z-TEL, YOUR PERSONAL COMMUNICATIONS CENTER, Z-TEL COMMUNICATIONS, INC.
and Design, Z-LINE COMPANION, Z-LINE MESSENGER, Z-TEL and DESIGN, Z-TEL
TECHNOLOGIES, INC.

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COMPETITION

Overview

The telecommunications industry is highly competitive in many market
segments. However, at present, we believe few telecommunications carriers
provide the type of bundled packages that include the range of services and
features we offer, but various competitors offer one or more of the services
that make up our service offerings. Competition in the local telephone services
market is still emerging, but already has attracted many strong competitors.
Competition in the long distance and information services markets, which have
fewer entry barriers, is already intense and is expected to remain so.

We believe the principal competitive factors affecting our business will
be the quality and reliability of our services, innovation, customer service
and price. Our ability to compete effectively will depend upon our continued
ability to offer innovative, high-quality, market-driven services at prices
generally equal to or below those charged by our competitors. Many of our
current and potential competitors have greater financial, marketing, personnel
and other resources than we do, as well as other competitive advantages.

Local Telephone Service

Incumbent Local Exchange Carriers.In each of our target markets, we will
compete with the incumbent local exchange carrier serving that area, which may
be one of the Bell operating companies. As a recent entrant in the
telecommunications services industry, we have not achieved and do not expect to
achieve in the foreseeable future a significant market share for any of our
services in our markets. In particular, the incumbent local exchange carriers
have long-standing relationships with their customers, have financial,
technical and marketing resources substantially greater than ours, have the
potential to subsidize services that compete with our services with revenue
from a variety of other unregulated businesses, and currently benefit from
certain existing regulations that favor the incumbent local exchange carriers
over us in certain respects.

Recent regulatory initiatives that allow competitive local exchange
carriers, such as us, to interconnect with incumbent local exchange carrier
facilities and acquire and combine the unbundled network elements of an
incumbent local exchange carrier provide increased business opportunities for
us. However, such interconnection opportunities have been, and will likely
continue to be, accompanied by increased pricing flexibility and relaxation of
regulatory oversight for the incumbent local exchange carriers.

Competitive Local Exchange Carriers.The Telecommunications Act radically
altered the market opportunity for competitive local exchange carriers.
Competitive access providers who entered the market prior to passage of the
Telecommunications Act built their own infrastructure to offer exchange access
services to large end-users. Since the passage of the Telecommunications Act,
many competitive access providers have added switches to become competitive
local exchange carriers in order to take advantage of the opening of the local
market. With the Telecommunications Act requiring unbundling of the incumbent
local exchange carriers networks, competitive local exchange carriers will now
be able to enter the market more rapidly by leasing switches, trunks and loop
capacity until traffic volume justifies building substantial facilities. Newer
competitive local exchange carriers, like us, will not have to replicate
existing facilities and can be more opportunistic in designing and implementing
networks, which could have the effect of increasing competition for local
exchange services.

Interexchange Carriers.We also expect to face competition from other
current and potential market entrants, including interexchange (long distance)
carriers such as AT&T, WorldCom, and Sprint, seeking to enter, reenter or
expand entry into the local exchange market. A continuing trend toward
consolidation of telecommunications companies and the formation of strategic
alliances within the telecommunications industry, as well as the development of
new technologies, could give rise to significant new competitors.

Long Distance Telephone Service

The long distance telecommunications industry has numerous entities
competing for the same customers and a high average churn rate because
customers frequently change long distance providers in response to the offering
of lower rates or promotional incentives by competitors. Our primary
competitors in the long distance market include major interexchange carriers
such as AT&T, WorldCom and Sprint, certain incumbent local exchange carriers
and resellers of long distance services. We believe that pricing levels are a
principal competitive factor in providing long distance telephone service. We
hope to avoid direct price competition by bundling long distance telephone
service with a wide array of value-added services.

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Incumbent local exchange carriers that offer a package of local, long
distance telephone and information services will be particularly strong
competitors. Incumbent local exchange carriers, including Verizon and SBC
Communications, are currently providing both long distance and local services
as well as certain enhanced telephone services we offer. We believe that the
Bell operating companies will attempt to offset market share losses in their
local markets by attempting to capture a significant percentage of the long
distance market.

Enhanced Services

We compete with a variety of enhanced service companies. Enhanced services
markets are highly competitive, and we expect that competition will continue to
intensify. Our competitors in these markets include Internet service providers,
web-based communications service providers and other telecommunications
companies, including the major interexchange carriers, incumbent local exchange
carriers, competitive local exchange carriers and wireless carriers.

Other Market Entrants

We may face competition in local, long distance and information services
from other market entrants such as electric utilities, cable television
companies, fixed and mobile wireless system operators, and operators of private
networks built for large end-users. All of these companies are free to offer
bundled services similar to those that we offer. Electric utilities have
existing assets and low cost access to capital that could allow them to enter a
market rapidly and accelerate network development. Cable television companies
are also entering the telecommunications market by upgrading their networks
with fiber optics and installing facilities to provide fully interactive
transmission of broadband voice, video and data communications. Wireless
companies have developed, and are deploying in the United States, wireless
technology as a substitute for traditional wireline local telephones. The World
Trade Organization agreement on basic telecommunications services could
increase the level of competition we face. Under this agreement, the United
States and 68 other member states of the World Trade Organization are committed
to open their respective telecommunications markets, including permitting
foreign companies to enter into basic telecommunications services markets. This
development may increase the number of established foreign-based
telecommunications carriers entering the U.S. markets.

The Telecommunications Act includes provisions that impose certain
regulatory requirements on all local exchange carriers, including competitive
local exchange carriers. At the same time, the Telecommunications Act expands
the FCCs authority to reduce the level of regulation applicable to any or all
telecommunications carriers, including incumbent local exchange carriers. The
manner in which these provisions are implemented and enforced could have a
material adverse effect on our ability to compete successfully against
incumbent local exchange carriers and other telecommunications service
providers.

GOVERNMENT REGULATION

Overview

Some of our services are regulated and some are not. In providing our
non-common carrier services such as voice mail, Find-Me notification and
directory services offered through Z-Line Features, we operate as an
unregulated provider of information services, as that term is defined in the
Communications Act of 1934 (the "Communications Act"), as amended by the
Telecommunications Act of 1996 (the "Telecommunications Act"), and as an enhanced
service provider, as that term is defined in the FCC rules. These operations
currently are not regulated by the FCC or the states in which we operate. In
providing Z-LineHOME and our long distance services, we are regulated as a
common carrier at the state and federal level and are subject to additional
rules and policies not applicable to providers of information services alone.
We are certificated as a facilities-based competitive local exchange carrier in
forty-eight states and we are currently seeking such certification in Alaska
and Hawaii. Z-Tel does not have authority and has not sought certification in
the District of Columbia. Z-Tel is certificated as a long-distance reseller
in all fifty states.

The local and long distance telecommunications services we provide are
regulated by federal, state, and, to some extent, local government authorities.
The FCC has jurisdiction over all telecommunications common carriers

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to the extent they provide interstate or international communications services.
Each state regulatory commission has jurisdiction over the same carriers with
respect to the provision of intrastate communications services. Local
governments sometimes seek to impose franchise requirements on
telecommunications carriers and regulate construction activities involving
public rights-of-way. Changes to the regulations imposed by any of these
regulators could have a material adverse effect on our business, operating
results and financial condition.

In recent years, the regulation of the telecommunications industry has
been in a state of flux as the United States Congress and various state
legislatures have passed laws seeking to foster greater competition in
telecommunications markets. The FCC and state utility commissions have adopted
many new rules to implement this legislation and encourage competition. These
changes, which are still incomplete, have created new opportunities and
challenges for us and our competitors. The following summary of regulatory
developments and legislation is intended to describe the most important, but
not all, present and proposed federal, state and local regulations and
legislation affecting the telecommunications industry. Some of these and other
existing federal and state regulations are the subject of judicial proceedings
and legislative and administrative proposals that could change, in varying
degrees, the manner in which this industry operates. We cannot predict the
outcome of any of these proceedings or their impact on the telecommunications
industry at this time. Some of these future legislative, regulatory or judicial
changes may have a material adverse impact on our business.

Specifically, as states re-evaluate pricing of network elements, it is
possible that some states could increase or lower rates over existing levels.
Currently, the incumbent local exchange carriers Verizon, BellSouth, SBC and
Qwest have rate cases pending before state regulatory commissions in at least
one state in each of their respective territories. Ongoing rate cases in
Florida, Georgia, Illinois, Pennsylvania, Massachusetts, Arizona and Minnesota
could significantly raise or lower the existing rates for some network elements
and network element combinations. Our intent is to be an active participant in
many of these rate cases and any others that might be critical to our
operations. We anticipate joining other competitive service providers in
arguing that existing rates and rates proposed by the incumbents are overstated
and do not reflect the true total element long run incremental costing
principles required by the FCC and the Telecommunications Act. The legality of
the FCC-prescribed methodology for calculating unbundled network element rates
is currently before the United States Supreme Court. In that proceeding,
incumbents have challenged the FCC pricing methodology. The U.S. Supreme
Courts decision could cause the FCC to implement new pricing methodology rules
and could cause many of the states in which we do business to re-assess their
rates for unbundled network elements and interconnection. While the prevailing
trends within the industry would predict the adoption of lower rates in
association with the provision of unbundled network elements and network
element combinations, we cannot predict the outcome of any pending or potential
rate case or judicial proceeding. Increases or decreases in rate levels charged
by incumbent local exchange carriers as a result of regulatory and/or judicial
review through rate case, court case or arbitration proceedings could
significantly impact our business plans.

FEDERAL REGULATION

FCC Policy on Enhanced and Information Services

In 1980, the FCC created a distinction between basic telecommunications
services, which it regulates as common carrier services, and enhanced services,
which remain unregulated. The FCC exempted enhanced service providers from
federal regulations governing common carriers, including the obligation to pay
access charges for the origination or termination of calls on carrier networks
and the obligation to contribute to the universal service fund. The
Telecommunications Act of 1996 established a similar distinction between
telecommunications services and information services. Changing technology and
changing market conditions, however, sometimes make it difficult to discern the
boundary between unregulated and regulated services.

In general, information services are value-added services that use
regulated transmission facilities only as part of a service package that also
includes network or computer software to change or enhance the information
transmitted. We believe that most of the services we provide, including voice
mail, Find-Me notification, and directory services offered through Z-Line
Features are information services under the FCCs definition. Because the
regulatory boundaries in this area are somewhat unclear and subject to dispute,
however, the FCC could seek to characterize some of our information services as
telecommunications services. If that happens, those services would become
subject to FCC regulation, although the impact of that reclassification is
difficult to predict. In

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particular, the FCC has announced its intention to address, in the near future,
the basic question as to how broadband services offered by wireline
telecommunications providers should be classified under the Communications Act
when such services are bundled with information services.

In general, the FCC does not regulate the rates, services, and market
entry and exit of non-dominant telecommunications carriers, but does require
them to contribute to universal service and comply with other regulatory
requirements. We are currently regulated as a non-dominant carrier with respect
to both our local and long distance telephone services.

FCC Regulation of Common Carrier Services

We currently are not subject to rate of return regulation at the federal
level and are not currently required to obtain FCC authorization for the
installation, acquisition or operation of our domestic exchange or
interexchange network facilities. However, we must comply with the requirements
of common carriage under the Communications Act of 1934. We are subject to the
general requirement that our charges and terms for our telecommunications
services be just and reasonable and that we not make any unjust or
unreasonable discrimination in our charges or terms. The FCC has jurisdiction
to act upon complaints against any common carrier for failure to comply with
its statutory obligations.

Comprehensive amendments to the Communications Act of 1934 were made by
the Telecommunications Act of 1996, which was signed into law on February 8,
1996. The Telecommunications Act effected changes in regulation at both the
federal and state levels that affect virtually every segment of the
telecommunications industry. The stated purpose of the Telecommunications Act
is to promote competition in all areas of telecommunications. While it may take
years for the industry to feel the full impact of the Telecommunications Act,
it is already clear that the legislation provides us with new opportunities and
challenges.

Interconnection and Unbundling Requirements.The Telecommunications Act
greatly expands the interconnection requirements applicable to the incumbent
local exchange carriers, i.e., generally, those existing local exchange
carriers that, in the past, enjoyed virtual or legal monopoly status. The
Telecommunications Act requires the incumbent local exchange carriers to:



| |  |  | provide physical collocation, which allows companies such as us and
other competitive local exchange carriers to install and maintain our
own network termination equipment in incumbent local exchange carrier
central offices or, if requested or if physical collocation is
demonstrated to be technically infeasible, virtual collocation;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | offer components of their local service networks on an unbundled basis
so that other providers of local service can use these elements in
their networks to provide a wide range of local services to customers;
and                                                                                                                          
|
| |  |  | establish wholesale rates for their services to promote resale by
competitive local exchange carriers.                                                                                                                                                                                                                                      

In addition, all local exchange carriers must



| |  |  | interconnect with the facilities of other carriers;                                                                                                                                    
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | establish number portability, which will allow customers to retain their existing phone numbers if they switch from the
local exchange carrier to a competitive local service provider;
|
| |  |  | provide nondiscriminatory access to telephone poles, ducts, conduits and rights-of-way; and                                                                                            
|
| |  |  | compensate other local exchange carriers on a reciprocal basis for traffic originated by one local exchange carrier and
terminated by another local exchange carrier.                  

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The FCC is charged with establishing national guidelines to implement
certain portions of the Telecommunications Act. The FCC issued its first
interconnection order on August 8, 1996. Among other rules, the FCC established
a list of seven network elements, comprising most of the significant
facilities, features, functionalities, or capabilities of the network, that the
incumbent local exchange carriers must unbundle. It is possible for competitors
to provide competitive local exchange service using only these unbundled
network elements. In addition, the FCC mandated a particular forward looking
pricing methodology for these network elements that produces relatively low
element prices that are favorable to competitors.

On July 18, 1997, however, the United States Court of Appeals for the
Eighth Circuit issued a decision vacating the FCCs pricing rules, as well as
certain other portions of the FCCs interconnection rules, on the grounds that
the FCC had improperly intruded into matters reserved for state jurisdiction.
On January 25, 1999, the Supreme Court largely reversed the Eighth Circuits
order, holding that the FCC has general jurisdiction to implement the local
competition provisions of the Telecommunications Act. In so doing, the Supreme
Court stated that the FCC has authority to set pricing guidelines for unbundled
network elements, to prevent incumbent local exchange carriers from physically
separating existing combinations of network elements, and to establish pick
and choose rules regarding interconnection agreements. Pick and choose rules
would permit a carrier seeking interconnection to pick and choose among the
terms of service from other interconnection agreements between the incumbent
local exchange carriers and other competitive local exchange carriers. This
action reestablished the validity of many of the FCC rules vacated by the
Eighth Circuit.

Although the Supreme Court affirmed the FCCs authority to develop pricing
guidelines, the Supreme Court did not evaluate the specific forward-looking
pricing methodology mandated by the FCC and has remanded the case to the Eighth
Circuit for further consideration. Some incumbent local exchange carriers have
argued that this pricing methodology does not allow adequate compensation for
the provision of unbundled network elements. The Eighth Circuit heard oral
arguments on this pricing issue on September 16, 1999 and issued a ruling on
July 18, 2000. In that ruling, the Eighth Circuit upheld the FCCs use of
forward-looking incremental costs as the basis for establishing rates for
interconnection and unbundled network elements. The Eighth Circuit further
agreed with the FCCs interpretation of the Telecommunications Act as rejecting
historical costs as the basis for setting rates. However, the Eighth Circuit
vacated the FCCs regulation, codified at 47 C.F.R. Sec. 51.505(b), setting
forth the FCCs approach to computing forward-looking incremental costs, and
directed the FCC to review its approach so that it is based on the costs
incurred by the incumbent local exchange carrier to provide the actual
facilities and equipment that will be used by the requesting carrier instead of
the lowest cost based on the most efficient technologies currently available.
On January 23, 2001, the United States Supreme Court granted a writ of
certiorari to the Eighth Circuit decision and that case has been argued and
briefed before the United States Supreme Court. If the United States Supreme
Court affirms the Eighth Circuits decision or reverses the other FCC pricing
rules that are the subject of that appeal, there is a risk that, upon remand,
the FCC will issue less favorable pricing methodology rules, and state public
utility commissions, some of whom have relied on the FCCs existing rules, may
revisit their pricing methodologies. As a result, the prices we have to pay for
unbundled network elements may increase, which increase could have a materially
adverse effect on our business.

In its January 25, 1999 decision, the Supreme Court also remanded the list
of unbundled network elements to the FCC for further consideration of the
necessity of each one under the Telecommunications Acts statutory standard for
unbundling. On November 5, 1999, the FCC released an order largely retaining
its list of unbundled network elements, but eliminating the requirement that
incumbent local exchange carriers provide unbundled access to operator services
and directory assistance and limiting unbundled access to local switching. With regard to
operator services and directory assistance, the FCC concluded that the market
has developed since 1996 such that competitors can and do self-provision these
services, or acquire them from alternative sources. The FCC also noted that
incumbent local exchange carriers remain obligated under the non-discrimination
requirements of the Communications Act of 1934 to comply with the reasonable
request of a carrier that purchases these services from the incumbent local
exchange carriers to rebrand or unbrand those services, and to provide
directory assistance listings and updates in daily electronic batch files. With
regard to unbundled local switching, the FCC concluded that, notwithstanding
the incumbent local exchange carriers general duty to provide unbundled local
circuit switching, an incumbent local exchange carrier is not required to
unbundle local circuit switching for competitors for end-users with four or
more voice grade (DSO) equivalents or lines, provided that the incumbent local
exchange carrier provides nondiscriminatory access to combinations of unbundled
loops and

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transport (also known as the Enhanced Extended Link) throughout Density Zone 1,
and the incumbent local exchange carriers local circuit switches are located
in (i) the top 50 Metropolitan Statistical Areas as set forth in Appendix B of
the Third Report and Order and Fourth Further Notice of Proposed Rulemaking in
FCC Docket No. 96-98, and (ii) in Density Zone 1, as defined in the FCCs
rules. For operator services and directory assistance, as well as for unbundled
local switching, the FCC noted that the competitive checklist contained in
Section 271 of the Communications Act of 1934 requires Bell operating companies
to provide nondiscriminatory access to these services. Thus, Bell operating
companies must continue to provide these services to competitors; however, Bell
operating companies may charge different rates for these offerings.

The FCCs November 5, 1999 ruling on unbundled network elements was
appealed by several parties to the DC Circuit, including incumbent local
exchange carriers. In addition, competitive carriers have sought
reconsideration of that decision, including the FCCs limitation on the
availability of unbundled local switching, before the FCC. The D.C. Circuit
appeal of the FCCs November 5, 1999 ruling has been briefed by the parties and
is set for argument in Spring 2002. In that appeal, incumbent local exchange
carriers argued that the FCCs standard for identifying unbundled network
elements was inconsistent with the Telecommunications Act and the January 25,
1999 Supreme Court decision. In addition, incumbent local exchange carriers
argued that the FCCs decision to order access to unbundled local switching,
which Z-Tel relies on to provide its local exchange service, was arbitrary and
capricious. If the D.C. Circuit rules in favor of the incumbents, there is a
risk that Z-Tel would no longer have the ability to purchase local switching
from incumbent local exchange carriers on an unbundled basis pursuant to
Section 251 of the Telecommunications Act. Such a result would limit our
ability to sell Z-Tel common carrier services and information services and
would have a significant materially adverse effect on our business

On December 20, 2001, the FCC released a Notice of Proposed Rulemaking in
CC Dockets No. 01-338, 96-98 and 98-147 as part of its comprehensive Triennial
Review of the unbundling rules it implemented on November 5, 1999. That FCC
proceeding will consider the circumstances under which incumbent local exchange
carriers will be required to make parts of their networks available to carriers
like Z-Tel on an unbundled basis pursuant to Section 251 of the
Telecommunications Act. The FCC has asked parties to comment on the
methodology it should use to identify unbundled network elements. Also, in
that proceeding, the FCC is specifically reviewing whether incumbents should be
required to offer on an unbundled basis local loops, subloops, network
interface devices, the high-frequency portion of the loop, switching,
interoffice transmission facilities, and all other network elements. In
addition, the FCC is considering the role of state commissions in determining
what network elements are to be available. The outcome of this Triennial
Review proceeding is uncertain. There is a substantial risk that in the
Triennial Review the FCC will eliminate, limit or curtail access to unbundled
network elements, including but not limited to unbundled local switching and
transport, that Z-Tel utilizes to provide its local exchange service to its
customers. Any such limitation on the availability of unbundled network
elements, especially unbundled local switching or transport, could have a
significant and substantial material adverse impact on Z-Tels business. Z-Tel
is actively participating in this FCC Triennial Review proceeding and is
devoting substantial, multifaceted resources to this effort. The FCC is
expected to issue its decision in this Triennial Review proceeding by the end
of calendar year 2002.

Also on December 20, 2001, the FCC issued a Notice of Proposed Rulemaking
in CC Docket No. 01-337 in which the FCC sought comment on regulatory
requirements for incumbent local exchange carrier provision of broadband
telecommunications services. In this proceeding, the FCC is considering
whether it should remove regulatory safeguards and common carrier obligations,
including unbundling regulations, on incumbent local exchange carrier broadband
networks. An FCC decision limiting unbundling or deregulating incumbent local
exchange carrier broadband networks could have a significant and material
adverse impact on our business. For example, incumbent local exchange carriers
may be able to offer consumers deregulated broadband network packages of local
exchange, information services and broadband service (such as DSL) that Z-Tel
would not be able to offer because Z-Tel would not have unbundled access to
that broadband network. In addition, because the incumbent local exchange
carrier broadband network in most instances utilizes the same network
facilities as the current incumbent local exchange dial tone network,
limitations on unbundling or deregulation of that broadband network could
inexorably make it difficult, more costly, or even impossible, for Z-Tel to
provide its current telecommunications and information services to consumers.

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On February 14, 2002, the FCC adopted a Notice of Proposed Rulemaking in
CC Docket No. 02-42 that proposed to classify incumbent local exchange carrier
provision of wireline broadband Internet access services as an
information service and regulate the provision of such services pursuant to
Title I of the Communications Act of 1934. In addition, the FCC sought comment
on whether its Computer II/Computer IIIrules, which govern access to incumbent
networks by third parties to provide information services. The proposed rules
could, if adopted without adequate assurances for competitive access, limit the
ability of new entrants to access and utilize the networks of incumbent local
exchange carriers to provide advanced, broadband Internet access and could
therefore harm Z-Tels ability to provide services to its customers.

These and other FCC determinations are likely to be the subject of further
appeals or reconsideration. Thus, while the Supreme Court has resolved many
issues, including aspects of the FCCs jurisdictional authority, other issues
remain subject to further consideration by the courts and the FCC. We cannot
predict the ultimate disposition of these matters.

Interconnection Agreements.The Telecommunications Act obligates incumbent
local exchange carriers to negotiate with us in good faith to enter into
interconnection agreements. Competitive local exchange carriers like us can
purchase unbundled network elements under such an agreement or under a tariff
or a Statement of Generally Available Terms filed with the state regulators.
Interconnection agreements are a prerequisite to obtaining access to the
incumbent local exchange carriers unbundled network elements and to provide
the connectivity to our network necessary to provision local exchange services,
including Z-LineHOME. To this end, we have entered into interconnection
agreements with the Bell operating company in all states where we currently
offer local exchange services except Michigan and Wisconsin, where we purchase
the unbundled network element platform under SBC Ameritechs tariff on file
with the Michigan and Wisconsin state commissions. Z-Tels interconnection
agreements with the Bell operating company for territories in Ohio, Maryland,
Massachusetts, New Jersey and West Virginia have been signed and are currently
awaiting approval. Interconnection agreements between Z-Tel and the former
(non Bell) GTE exchanges now owned by Verizon have been signed and are
currently awaiting approval in Arizona, California, Florida, Idaho, Indiana,
and North Carolina.

To ensure that it obtains interconnection and unbundled access at the
best-available terms, Z-Tel currently is reviewing available contracts or
negotiating new contracts in a number of states. However, at any point in time
our interconnection agreement may not contain the best-available terms offered
to our competitors, a situation that could adversely affect our ability to
compete in the market. In addition, our interconnection agreements with SBC in
Missouri and Illinois have expired, and these agreements and others are in the
process of renegotiation.

If we cannot reach a voluntary interconnection agreement with an incumbent
local exchange carrier on acceptable terms, either side may petition the
applicable state commission to arbitrate remaining disagreements. These
arbitration proceedings can last for a substantial period of time and can
require substantial resources to litigate. Moreover, state commission approval
of any interconnection agreement resulting from negotiation or arbitration is
required, and any party may appeal an adverse decision by the state commission
to federal district court. The incentive of the incumbent local exchange
carrier to negotiate fair or proper interconnection agreement terms is a
function of the willingness and authority of state commissions and the FCC to
enforce rules and policies promulgated under the Telecommunications Act. The
potential cost in resources and delay from this interconnection agreement
negotiation and arbitration process could harm our ability to compete in
certain markets, and there is no guarantee that a state commission would
resolve disputes, including pricing disputes, in our favor.

The ability of a new entrant like Z-Tel to enforce interconnection
agreements with incumbent local exchange carriers or appeal state commission
arbitrations regarding such agreements is currently subject to considerable
legal uncertainty. A January 2002 decision by the United States Circuit Court
for the Eleventh Circuit ruled that the Georgia state commission did not have
authority to enforce interconnection agreements between incumbent local
exchange carriers and new entrants. This decision is in apparent conflict with
decisions by other United States Circuit Courts. As a result of this decision,
litigating enforcement of interconnection agreements in state or federal courts
in the Eleventh Circuit and elsewhere could substantially increase the cost of
such litigation. In addition, the United States Supreme Court has agreed to
review conflicting decisions by the Seventh Circuit and Fourth Circuit
regarding the ability of carriers to appeal state commission interconnection
agreement arbitrations and determinations in federal district court. State
commissions have argued that the Eleventh Amendment precludes appeal of these
decisions and determinations to federal district court. If carriers like Z-Tel
are required to appeal state commission decisions and determinations before
state courts, our ability to ensure uniform national unbundling
and interconnection principles could be significantly diminished and could
be significantly more costly and time-consuming to obtain.

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Collocation.The FCC has adopted rules designed to make it easier and less
expensive for competitive local exchange carriers to collocate equipment at
incumbent local exchange carriers central offices by, among other things,
restricting the incumbent local exchange carriers ability to prevent certain
types of equipment from being collocated and requiring incumbent local exchange
carriers to offer alternative collocation arrangements. Restrictions and
impediments to collocation could harm our business as they make it more
difficult if not impossible for us to obtain alternatives to unbundled network
elements we purchase from incumbent local exchange carriers.

On March 17, 2000, the United States Court of Appeals for the District of
Columbia Circuit vacated portions of the FCCs collocation rules. Specifically,
the court found that the FCCs interpretations of the statutory terms
necessary and physical collocation were impermissibly broad, and remanded
those portions of the order to the FCC for reconsideration. On August 8, 2001,
the FCC released an order on remand in response to this D.C. Circuit decision
in CC Docket 98-147. The FCC decided that competitors may collocate equipment
in incumbent local exchange carrier central offices if the competitor, as a
practical, economic or operational matter would be precluded form obtaining
equal in quality interconnection or nondiscriminatory access to unbundled
network elements. The FCC limited which multi-functional equipment competitors
may collocate. The FCC also decided that incumbent local exchange carriers
must comply with reasonable requests for competitors to install and maintain
cross-connections with collocated equipment of other competitors. The FCC also
decided that incumbent local exchange carriers may decide where collocated
equipment may be placed within its premises as long as the incumbent local
exchange carrier acts reasonably and nondiscriminatorily. The FCC also that
determined except in limited circumstances, an incumbent local exchange carrier
may separate the space collocators. The FCCs new collocation rules could
increase the cost and time for competitors to collocate equipment in incumbent
local exchange carrier central offices and could have a substantial and
material impact on Z-Tels future business prospects. This FCC Collocation
Remand Order is currently on appeal to the D.C. Circuit. The outcome of that
subsequent appeal is uncertain and could impact Z-Tels business.

Line Sharing and Line Splitting. On November 18, 1999, the FCC also
adopted an order requiring incumbent local exchange carriers to provide line
sharing, which will allow competitive local exchange carriers to offer data
services over the same line that a consumer uses for voice services without the
competitive local exchange carriers having to provide the voice service. In an
Order on Reconsideration, issued January 19, 2001, the FCC reaffirmed its prior
decision to support line sharing for provision of digital subscriber line (DSL)
services. In addition, in this January 19, 2001 decision, the FCC stated that
incumbent local exchange carriers must permit competitive local exchange
carriers to engage in line splitting arrangements, where a competitive local
exchange carrier provides voice and another provides data service to end-users
over a split loop purchased as an unbundled network element from the
incumbent local exchange carrier. While we expect that the FCCs rules will be
beneficial to competitive local exchange carriers, we cannot be certain that
these rules will be implemented by the incumbent local exchange carrier in a
timely or favorable manner. As a result, Z-Tels ability to offer its
customers DSL service and voice service by use of line-splitting and the
unbundled network element platform combination is restricted significantly by
incumbent local exchange carriers. That restriction could harm our business
and our ability to match the service packages and bundles offered by our
competitors.

Moreover, several key issues regarding line sharing, including the
provision of line sharing in instances where loop facilities have fiber
components and where remote terminals do not have sufficient space for
collocation, remain in light of the FCCs Further Notice of Proposed Rulemaking
issued in conjunction with its January 19, 2001 Order on Reconsideration. In
addition, the FCCs Triennial Review notice, released on December 20, 2001,
seeks comment on all of the FCCs unbundling rules, including line-sharing and
line-splitting. Any decision by the FCC in these proceedings could limit
Z-Tels unbundled access to the incumbent local exchange carrier networks in a
manner that could have a substantial and material impact on our current or
future business.

Bell Operating Company Entry into the Long Distance Market.The
Telecommunications Act permitted the Bell operating companies (Verizon, SBC,
Qwest, and BellSouth) to provide long distance services outside their local
service regions immediately, and permits them to provide in-region long
distance service upon demonstrating to the FCC that they have adhered to the
Telecommunication Acts Section 271 14-point competitive checklist. The FCC
must also find that granting the application would be in the public interest.

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Bell operating companies typically seek approval from state public utility
commissions prior to filing an application for Section 271 relief before the
FCC. To date, some states have denied these applications while others have
approved them. The Bell operating company can file an application with the FCC
for Section 271 relief regardless of the outcome of the states review. Based
on its own review as well as recommendations from the United States Department
of Justice and the involved state public utility commission, the FCC then
either approves or denies the application.

Prior to December 1999, the FCC had denied each of the Bell operating
company applications brought before it because it found that the particular
Bell operating company had not sufficiently made its local network available to
competitors. However, since December 1999, the FCC has not rejected a Section
271 application submitted by any Bell operating company, although several
applications have been withdrawn after being submitted. In late December 1999,
the FCC approved Verizons Section 271 application for the state of New York.
Since that time, the FCC has approved Verizons Section 271 applications for
Massachusetts, Pennsylvania, Connecticut and Rhode Island. In 2000 and 2001,
the FCC approved Section 271 applications of SBC for the states of Texas,
Kansas, Oklahoma, Missouri, and Arkansas. Currently pending before the FCC are
Section 271 applications by Verizon for New Jersey and Vermont and by BellSouth
for Georgia and Louisiana. SBC, BellSouth, and Qwest have no pending
applications before the FCC. On December 20, 2001, BellSouth withdrew its
Section 271 application for Georgia and Louisiana, but refiled February 14,
2002.

Several state public utility commissions (including, among others,
Arizona, California, Colorado, Florida, Georgia, Illinois,
Michigan and  Minnesota) have proceedings underway in association with anticipated Section 271
applications. While we cannot predict the outcome of any Section 271
applications before the FCC or any individual state, we expect Bell operating
companies to file applications for long distance authority in most of the
remaining states in 2002 and 2003 and that the FCC will grant many, if not
most, of those applications, despite the objections of competitive carriers and
the Department of Justice.

It is generally expected that competition for Z-Tels long-distance
services will increase as the Bell operating companies enter the market.
Section 271 entry permits the Bell operating company to offer a bundle of
local, long-distance and enhanced services comparable to Z-Tels services and
therefore could increase competition and harm our business, especially if we
cannot obtain adequate access to unbundled network elements from that same Bell
operating company.

The Section 271 process also provides an important incentive for Bell
operating companies to comply with the unbundling and interconnection
requirements of the Telecommunications Act. Z-Tel relies upon obtaining
unbundled access and interconnection with Bell operating companies to provide
its services to its customers; as a result, Z-Tel has a direct business
interest in ensuring that the Bell operating companies comply with the law.
Granting a Bell operating company long-distance authority pursuant to Section
271 in a state where the Bell operating company has not fully-complied with the
law could have a significant and material adverse impact on Z-Tels business,
as it would diminish the incentive of Bell operating companies to comply with
the law nationwide. On September 19, 2001, the FCC granted Verizons Section
271 application for Pennsylvania, despite the strong objections of Z-Tel and
other competitors that Verizons operational systems in that state were
discriminatory. In October 2001, Z-Tel appealed that FCC decision before the
United States Circuit Court for the District of Columbia. That appeal is
pending. If Z-Tel is not successful in this litigation, the incentive of Bell
operating companies to comply with their interconnection and unbundling
obligations fully could be significantly diminished, which could have a
material adverse impact on our business.

In December 2001, the United States Circuit Court for the District of
Columbia remanded the FCCs decision to grant SBC long-distance authority in
Kansas and Oklahoma. The court ruled that the FCC had not fully considered
whether granting such authority was in the public interest, given the alleged
potential for a price squeeze between regulated retail and wholesale rates
for local service. This proceeding has been remanded to the FCC. It is
unclear how and when the FCC will decide the issue on remand. In Verizons
pending New Jersey Section 271 application, Z-Tel has raised a similar price
squeeze public interest argument, and the FCC must issue a ruling on this
issue in this proceeding by March 2002. If the FCC rejects Z-Tels argument,
the ability for entrants to use the Section 271 process as a method of
achieving lower wholesale rates for unbundled network elements could be
substantially diminished.

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Universal Service.In May 1997, the FCC released an order establishing a
significantly expanded universal service regime to subsidize the cost of
telecommunications service to high cost areas, as well as to low-income
customers and qualifying schools, libraries and rural health care providers.
Providers of interstate telecommunications services, like us, as well as
certain other entities, must pay for these programs. We are also eligible to
receive funding from these programs if we meet certain requirements. Our share
of the payments into these subsidy funds is based on our share of certain
defined interstate telecommunications end-user revenues. Currently, the FCC is
assessing such payments on the basis of a providers revenue for the previous
year. The FCC adjusts payment requirements and levels periodically. Various
states are also in the process of implementing their own universal service
programs. We are currently unable to quantify the amount of subsidy payments
that we will be required to make to individual states. On July 30, 1999, the
United States Court of Appeals for the Fifth Circuit overturned certain of the
FCCs rules governing the basis on which the FCC collects subsidy payments from
telecommunications carriers and recovery of those payments by incumbent local
exchange carriers. In October 1999, on remand, the FCC issued new universal
service rules. These or other changes to the universal service program could
affect our costs.

The FCC rules are pending review before the Fifth Circuit. The outcome of
that litigation and subsequent and forthcoming FCC and state determinations
could adversely impact or delay our ability to obtain universal service funding
for our services or our ability to compete with carriers that do obtain such
funding. The FCC is also seeking comment on how to assess and collect funds
from carriers to support the universal service system. Changes to this support
program could adversely affect our costs, our ability to separately-list these
charges on end-user bills, and our ability to collect these fees from our
customers.

Interstate Tariffs and Rates.Beginning July 31, 2001, interstate domestic
long distance companies were no longer allowed to file interstate long-distance
end-user tariffs with the FCC. This regulatory change requires that Z-Tel must
make its long-distance service information directly available to customers
pursuant to private contracts. In March 1999, the FCC adopted rules that
require interexchange carriers like Z-Tel to make specific disclosures on their
web sites of their rates, terms and conditions for domestic interstate
services. These detariffing and disclosure requirements could increase our
costs in providing interstate long-distance services to our subscribers.

On April 27, 2001, the FCC limited the ability of nondominant, competitive
local exchange carriers, including Z-Tel, to file tariffs for interstate
switched access services. In doing so, the FCC effectively regulates the rates
Z-Tel charges long-distance companies for interstate switched access services.
Local exchange carriers (like Z-Tel) provide interstate switched access
services to interexchange long-distance companies (like AT&T, MCI, and Sprint)
when a state-to-state long distance call is made to or placed by a local
telephone customer. Given the large number of interstate long-distance
companies, these interstate switched access services are provided generally
through FCC interstate tariffs. Prior to this April 27, 2001 decision, the FCC
had refrained from any price regulation of the interstate access rates of
competitive local exchange companies like Z-Tel. With the April 27, 2001
Report and Order in CC Docket No. 96-262, the FCC ruled that it would not
accept for filing any interstate switched access tariff filing by a competitive
local exchange carriers if the per-minute rate exceeded an FCC benchmark. The
FCC benchmark varies by metropolitan statistical area. In metropolitan
statistical areas (MSAs) that a competitive local exchange carrier began to
provide service after June 20, 2001 (the effective date of the Order), the FCC
benchmark rate is the interstate switched access rate for the competing
incumbent local exchange carrier, which is established pursuant to
publicly-filed tariffs before the FCC. For MSAs in which a carrier was
providing local service in as of June 20, 2001, the FCC benchmark rate from
June 20, 2001 through June 19, 2002 is 2.5 cents per minute or the competing
incumbent local exchange carrier rate, whichever is higher. For those same
MSAs, the FCC benchmark rate from June 20, 2002 through June 19, 2003 is 1.8
cents per minute or the competing incumbent local exchange carrier rate,
whichever is higher. For those same MSAs, the FCC benchmark rate from June 20,
2003 through June 19, 2004 is 1.2 cents per minute or the competing incumbent
local exchange carrier rate, whichever is higher. Beginning on June 20, 2004,
the FCC benchmark rate for those MSAs will be the switched access rate of the
competing incumbent local exchange carrier. As of June 20, 2001, Z-Tel was
providing local service in most of the MSAs in its current footprint; as a
result, the FCC benchmark rates for Z-Tels interstate switched access charges
in those MSAs will, through June 20, 2004, be considerably higher than the FCC
benchmark rate for Z-Tels competitors that begin to provide service in those
MSAs after June 20, 2001.

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AT&T and Sprint have appealed the FCCs April 2001 CLEC Access Charge
Order before the United States Circuit Court for the District of Columbia,
arguing that the FCCs benchmark rates are too high and that competitive local
exchange carriers like Z-Tel should be required to provide interstate switched
access services at the competing incumbent local exchange carrier rate
immediately. Z-Tel has intervened in that court proceeding against those
long-distance companies. Two competitive local exchange carriers have also
appealed the FCC decision, and several competitive carriers have sought
reconsideration or clarification of the FCCs decision. In addition, Z-Tel has
sought a waiver of FCC rules requiring it to tariff interstate switched access
services at the competing incumbent local exchange carrier rate for several
dozen smaller MSAs that Z-Tel did not have any local subscribers in as of June
20, 2001, arguing to the FCC that the cost to Z-Tel to provide interstate
switched access services at two different rate levels in the same state would
impose unnecessary costs on Z-Tel that is inconsistent with the public
interest. These appeals, reconsiderations, and the waiver request are all
pending. The outcome of any of these determinations could have a significant
and material impact on Z-Tels business. In particular, if AT&T and Sprint are
successful in requiring Z-Tel and other entrants to charge the competing
incumbent local exchange carrier rate for interstate switched access services
immediately, it would have a substantial and material adverse effect on Z-Tels
business and competitive advantage.

In 2001, Z-Tel settled pending litigation with AT&T and Sprint over their
nonpayment of access charges to Z-Tel. Z-Tel provides interstate and
intrastate switched access services to both of those long-distance carriers
pursuant to switched access service agreements. Based on history of nonpayment
of both of these long-distance carriers to Z-Tel, there is a risk that either
or both of these long-distance companies could fail to pay Z-Tel for switched
access services. While Z-Tel has in the past and will in the future adamantly
litigate and defend its position against these carriers, nonpayment could have
a substantial and material adverse impact on our business.

Numbering and Number Portability.In August 1997, the FCC issued rules
transferring responsibility for administering and assigning local telephone
numbers from the Bell operating companies and other incumbent local exchange
carriers to a neutral entity in each geographic region in the United States. In
August 1996, the FCC issued new numbering regulations that prohibit states from
creating new area codes that could unfairly hinder competitive local exchange
carriers by requiring their customers to use 10 digit dialing while existing
incumbent local exchange carrier customers use seven digit dialing. In
addition, each carrier is required to contribute to the cost of numbering
administration through a formula based on net telecommunications revenues.
Beginning in March 2000, contributions for this purpose were based on end-user
telecommunications revenues and have been submitted in association with FCC
Lifeline, Universal Service and the Schools and Libraries Funds.

In July 1996, the FCC released rules requiring all local exchange carriers
to have the capability to permit both residential and business consumers to
retain their telephone numbers when switching from one local service provider
to another, known as number portability. Number portability has been
implemented in most of the areas in which we provide service, but has not been
implemented everywhere in the United States. Some carriers have obtained
waivers of the requirement to provide number portability, and others have
delayed implementation by obtaining extensions of time before compliance is
required. Lack of number portability in a given market could adversely affect
our ability to attract customers for our competitive local exchange service
offerings, particularly business customers, should we seek to provide services
to such customers.

In May 1999, the FCC also initiated a proceeding to address the problem of
the declining availability of area codes and phone numbers. On December 29,
2000, the FCC issued a Further Notice of Proposed Rulemaking in CC Dockets No.
96-98 and 99-200 that proposed adoption of a market-based approach for
optimizing number resources. In that Further Notice the FCC seeks input on its
tentative conclusion that, through the introduction of charges associated with
the allocation of number resources, carriers might be better incentivized to
take and retain only as many numbers as they need. If a market-based approach
to number allocation is introduced, as the FCC has proposed, it could result in
added administrative expenses for us.

Restrictions on Bundling.Current FCC rules prohibit dominant carriers
from bundling their non-competitive regulated telecommunications services with
their unregulated enhanced or information services. To our knowledge, the FCC
has not enforced this rule with respect to competitive local exchange carriers
and has proposed eliminating the rule for all carriers.

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Slamming.A customers choice of local or long distance telecommunications
company is encoded in a customer record, which is used to route the customers
calls so that the customer is served and billed by the desired company. A user
may change service providers at any time, but the FCC and some states regulate
this process and require that specific procedures be followed. When these
procedures are not followed, particularly if the change is unauthorized or
fraudulent, the process is known as slamming. Slamming is such a significant
problem that it has been addressed in detail by Congress in the
Telecommunications Act, by some state legislatures, and by the FCC in recent
orders. The FCC has levied substantial fines for slamming. The risk of
financial damage, in the form of fines, penalties and legal fees and costs, and
to business reputation from slamming is significant. Even one slamming
complaint could cause extensive litigation expenses for us. The FCC recently
decided to apply its slamming rules (which originally covered only long
distance) to local service as well. Z-Tel is also subject to state rules and
regulations regarding slamming, cramming, and other consumer protection
regulation.

Network Information.Section 222 of the Communications Act of 1934 and FCC
rules protect the privacy of certain information about telecommunications
customers that a telecommunications carrier such as us acquires by providing
telecommunications services to such customers. Such protected information,
known as Customer Proprietary Network Information (CPNI), includes information
related to the quantity, technological configuration, type, destination and the
amount of use of a telecommunications service. The FCCs original rules
prevented a carrier from using CPNI acquired through one of its offerings of a
telecommunications service to market certain other services without approval of
the affected customer. The United States Court of Appeals for the Tenth
Circuit overturned a portion of the FCCs rules established in CC Docket No.
96-115 regarding the use and protection of CPNI.

In response to the Tenth Circuit decision, in October 2001, in CC Docket
No. 96-115, the FCC clarified that the Tenth Circuit reversal was limited and
that most of the FCCs CPNI rules remained in effect. The FCC sought further
comment on what method of customer consent offered by a carrier (either an
opt-in or opt-out approach) would serve the governmental interest in
Section 222 and be consistent with the First Amendment. The final
determination of this issue and other FCC rules regarding handling of CPNI
could result in significant administrative expense to Z-Tel in modifying
internal customer systems to meet these requirements.

Intercarrier Compensation (Interstate Access Charges and Reciprocal
Compensation).Because Z-Tel, as a competitive local exchange carrier, passes
and receives local and toll calls to and from other local exchange carriers and
long-distance companies, the rates for intercarrier compensation for these
calls has a significant and substantial impact on the profitability of Z-Tels
business. In addition, the rates that Z-Tels competitors, especially the
incumbent local exchange carriers, are permitted to charge end-users, other
local exchange carriers, and long-distance companies for originating,
transmitting, and terminating telecommunications traffic can have a substantial
impact on Z-Tels ability to offer services in competition with those carriers.

The current regulatory (and intercarrier compensation) status of dial-up
calls to Internet service providers is in dispute and litigation. The FCC has
determined that both continuous access and dial-up calls from a customer to an
Internet service provider are interstate, not local, calls, and, therefore, are
subject to the FCCs jurisdiction. The FCC has initiated a proceeding to
determine the effect that this regulatory classification will have on the
obligation of local exchange carriers to pay reciprocal compensation for
dial-up calls to Internet service providers that originate on one local
exchange carrier network and terminate on another local exchange carrier
network. Moreover, many states have or are considering this issue, and several
states have held that local exchange carriers do not need to pay reciprocal
compensation for calls terminating at Internet service providers. A majority of
state commissions have ruled that reciprocal compensation should be paid on
such traffic. On March 24, 2000, the Court of Appeals for the District of
Columbia remanded for reconsideration the FCCs determination that calls to
Internet service providers are interstate for jurisdictional purposes rather
than local. Specifically, the Court indicated that the FCC has not provided a
satisfactory explanation why calls to Internet service providers are not local
telecommunications traffic and why such traffic is exchange access rather than
telephone exchange service. We cannot predict the effect that the FCCs
resolution of these issues will have on our business.

Since passage of the Telecommunications Act of 1996, the FCC has
fundamentally restructured the access charges that incumbent local exchange
carriers charge to interexchange carriers and end-user customers to connect to
the incumbent local exchange carriers network. The FCC revised access charges
for the largest incumbent local exchange carriers in May 1997, reducing
per-minute access charges and increasing flat-rated monthly charges paid

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by both long-distance carriers and end-users. Further changes in access
charges were effected for the largest incumbent local exchange carriers when
the FCC adopted the Coalition for Affordable Local and Long-Distance Service
(CALLS) proposal in May 2000. CALLS, which reflected a negotiated settlement
between AT&T and most of the Bell operating companies, reduced per-minute
charges by 60 percent. It further increased flat-rated monthly charges to
end-users, in particular, multi-line business users. The CALLS plan also
attempted to remove implicit universal service subsidies paid for by
long-distance companies in interstate access rates and place those funds into
the federal universal service support system, where they would be recovered
from all interstate carriers. Most of the reductions in the CALLS plan
resulted from shifting access costs away from interexchange carriers onto
end-user customers. Last year, the Fifth Circuit reversed and remanded
portions of the CALLS plan back to the FCC for further consideration of the
issue as to the size of the subsidy for universal service should be removed
from the interstate access charges and placed into the federal interstate
universal service support system. The outcome of this litigation could impact
the contributions Z-Tel, as an interstate carrier, must pay to support the
federal universal service support system.

In addition, as discussed above, the rates that Z-Tel and other
competitive local exchange carriers may charge for interstate switched access
services are regulated pursuant to the FCCs April 2001 CLEC Access Charge
Order.

In April 2001, the FCC released a Notice of Proposed Rulemaking in CC
Docket No. 01-92 in which it proposed a fundamental re-examination of all
currently regulated forms of intercarrier compensation. The FCC proposed that
carriers transport and terminate local traffic on a bill-and-keep basis, rather
than per-minute reciprocal compensation charges. The FCC regards the CALLS
Order and the CLEC Access Charge Order as well as its reciprocal compensation
rules to be 3-year transitional intercarrier compensation regimes. After
completion of that three-year transition, a new interstate intercarrier
compensation regime based upon bill-and-keep or another alternative may be in
place. Because Z-Tel both makes payments to and receives payments from other
carriers for exchange of local and long-distance calls, at this time we cannot
predict the effect that the FCCs determination in CC Docket No. 01-92 may have
upon our business.

Potential Legislation. On February 27, 2002, the U.S. House of
Representatives passed H.R. 1542, (the Tauzin-Dingell bill). If enacted into
law, H.R. 1542 would overturn a substantial portion of the Telecommunications
Act, including several of the unbundling requirements. In addition, H.R. 1542
would permit Bell operating companies to offer interLATA data services
immediately without Section 271 approval. As a result, enactment would
significantly and substantially lower the incentive for the Bell operating
companies to provide interconnection and access to unbundled network elements
to competitors like Z-Tel. If enacted, H.R. 1542 also would substantially
deregulate broadband telecommunications services offered by incumbent local
exchange carriers and limit unbundled access to such broadband networks. Such
deregulation action could have a significant and material adverse impact on our
business. Other changes to the market-opening and enforcement provisions of
the Communications Act could adversely affect our ability to provide
competitive services and could harm our business.

Other Issues.There are a number of other issues and proceedings that
could have an effect on our business in the future, including the fact that



| |  |  | The FCC has adopted rules to require telecommunications service
providers to make their services accessible to individuals with
disabilities, if readily achievable.                                                                                                                                                             
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The FCC has also ordered telecommunications service providers to
provide law enforcement personnel with a sufficient number of ports
and technical assistance in connection with wiretaps. We cannot
predict the cost to us of complying with this order.                                                                        
|
| |  |  | The FCC has adopted new rules designed to make it easier for customers
to understand the bills of telecommunications carriers. These
Truth-in-Billing rules establish certain requirements regarding the
formatting of bills and the information that must be included on
bills. These rules have been appealed in Federal court.

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| |  |  | We are subject to annual regulatory fees assessed by the FCC, and must
file an annual employment report to comply with the FCCs Equal
Employment Opportunity policies.                                                                                                    
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The FCC has adopted an order granting limited pricing flexibility to
large incumbent local exchange carriers, and is considering granting
additional pricing flexibility and price deregulation options. These
actions could increase competition for some of our services.

The foregoing is not an exhaustive list of proceedings or issues that
could materially affect our business. We cannot predict the outcome of these or
any other proceedings before the courts, the FCC, legislative bodies, or state
or local governments.

STATE REGULATION

To the extent that we provide telecommunications services that originate
and terminate within the same state, we are subject to the jurisdiction of that
states public service commission. As our local service business and product
lines expand, we will offer more intrastate services and may become
increasingly subject to state regulation. The Telecommunications Act maintains
the authority of individual state utility commissions to preside over rate and
other proceedings, and to impose their own regulation on local exchange and
intrastate interexchange services, so long as such regulation is not
inconsistent with the requirements of federal law. For instance, states may
require us to obtain a Certificate of Public Convenience and Necessity before
commencing service in the state. We have obtained such authority in all states
in which we operate, and, as a prelude to market entry in additional states, we
have obtained such authority to provide facilities-based service in forty-eight
states. Z-Tel has sought such authority also in Alaska and Hawaii. Z-Tel has
not applied for such authority in the District of Columbia. No assurance can
be made that the individual state regulatory authorities will approve these or
additional certification requests in a timely manner. In addition to requiring
certification, state regulatory authorities may impose tariff and filing
requirements, consumer protection measures, and obligations to contribute to
universal service and other funds. State commissions also have jurisdiction to
approve negotiated rates, or establish rates through arbitration, for
interconnection, including rates for unbundled network elements. Changes in
those rates for unbundled network elements could have a substantial and
material impact on our business. Our ability to appeal State commission
determinations in federal court is subject to considerable legal uncertainty
(see Interconnection Agreements above).

We are subject to requirements in some states to obtain prior approval
for, or notify the state commission of, any transfers of control, sales of
assets, corporate reorganizations, issuance of stock or debt instruments and
related transactions. Although we believe such authorizations could be obtained
in due course, there can be no assurance that state commissions would grant us
authority to complete any of these transactions.

We are also subject to state laws and regulations regarding slamming,
cramming, and other consumer protection and disclosure regulations. These
rules could substantially increase the cost of doing business in any one
particular state. State commissions have issued or proposed several
substantial fines against competitive local exchange companies for slamming or
cramming. The risk of financial damage, in the form of fines, penalties and
legal fees and costs, and to business reputation from slamming is significant.
Even one slamming complaint before a state commission could cause extensive
litigation expenses for us. In addition, state law enforcement authorities may
utilize their powers under state consumer protection laws against us in the
event legal requirements in that state are not met.

Z-Tels rates for intrastate switched access services, which Z-Tel
provides to long-distance companies to originate and terminate in-state toll
calls, are subject to the jurisdiction of the state commissions in which the
call originated and terminated. State commissions may, like Texas, directly
regulate or prescribe this intrastate switched access rate. Such regulation by
other states could materially and adversely affect Z-Tels revenues and
business opportunities within that state.

The Telecommunications Act generally preempts state statutes and
regulations that restrict the provision of competitive services. As a result of
this preemption, we will be generally free to provide the full range of local,
long distance, and data services in any state. While this action greatly
increases our potential for growth, it also increases the amount of competition
to which we may be subject. States, however, may still restrict Z-Tels ability
to provide

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competitive services in some rural areas. In addition, the cost of enforcing
federal preemption against certain state policies and programs may be large and
may cause considerable delay. In particular, we expect to expand our Z-LineHOME
service by starting to market this service in several new states during 2002.
To effect entry into these markets, we have obtained proper state regulatory
certification and entered into interconnection agreements in all states where
we operate, except for Michigan and Wisconsin, where we obtain interconnection
and access to unbundled network elements through a state tariff. In each
jurisdiction where we operate, we anticipate that the incumbent local exchange
carrier will provide the unbundled network element platform components in a
manner similar to that provided in states where we currently operate. However,
pricing and terms and conditions adopted by the incumbent local exchange
carrier in each of these states may preclude our ability to offer a
competitively viable and profitable product within these and other states on a
going-forward basis.

In order to enter new markets, we may be required to negotiate
interconnection agreements with incumbent local exchange carriers on an
individual state basis. To continue to provide service, we also need to
renegotiate interconnection agreements with incumbent local exchange carriers.
While current FCC rules and regulations require the incumbent provider to
provide the network elements on an individual and combined basis necessary for
us to provision end-user services, no assurance can be made that the individual
local exchange providers will provide these components in a manner and at a
price that will support competitive operations. If the incumbent providers do
not readily provide network functionality in the manner required, we have
regulatory and legal alternatives, including arbitration before state public
service commissions, to force provision of services in a manner required to
support our service offerings. However, if we are forced to litigate in order
to obtain the combinations of network elements required to support our service,
we are likely to incur significant incremental costs and delays in entering
such markets. In addition, as discussed above, there is considerable legal
uncertainty as to how interconnection agreements are to be enforced before
state commissions and where appeals of state commission interconnection
agreement determinations may be heard.

LOCAL GOVERNMENT REGULATION

In some of the areas where we provide service, we may be subject to
municipal franchise requirements requiring us to pay license or franchise fees
either on a percentage of gross revenue, flat fee or other basis. We may be
required to obtain street opening and construction permits from municipal
authorities to install our facilities in some cities. The Telecommunications
Act prohibits municipalities from discriminating among telecommunications
service providers in imposing fees or franchise requirements. In some
localities, the FCC has preempted fees and other requirements determined to be
discriminatory or to effectively preclude entry by competitors, but such
proceedings have been lengthy and the outcome of any request for FCC preemption
would be uncertain.

EMPLOYEES

As of March 22,
2002, we had approximately 1,332 employees. None of our
employees is covered under collective bargaining agreements, and we believe
that our relationships with our employees are good.




Item 2.Properties

We currently lease our principal executive offices in Tampa, Florida, our
principal engineering offices in Atlanta, Georgia and our call center offices
in Minot, North Dakota. We own our principal consumer services offices in
Atmore, Alabama.




Item 3.Legal Proceedings

We are a party to various routine administrative proceedings. For more
information, please refer to the section entitled Item 1. Business-Government
Regulation.



|1. |  | Case Number 1:01CV00551; Z-Tel Communications, Inc. v AT&T Corp.; in the
United States District Court for the District of Columbia.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------

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On March 15, 2001, we filed the captioned suit. In that suit, we have
alleged that AT&T has received originating and terminating access service from
us and has unlawfully withheld access charges for such services from us. In
July 2001, AT&T and the Company agreed to a settlement. In connection with that
settlement, which approximated the amounts recorded by the Company as
receivables, the Company resolved the issues relating to charges for access
services rendered. The Company entered into a switched access agreement setting
forth terms and conditions under which AT&T will purchase access services from
the Company in the future.



|2. |  | Case No. 01 CV 5074; Grosinger v. Z-Tel Technologies, Inc., et al., in
the United States District Court for the Southern district of New York
(filed June 7, 2001)
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

During June and July 2001, three separate class action lawsuits were filed
against the Company, certain of the Companys current and former directors and
officers (the D&Os) and firms engaged in the underwriting (the
Underwriters) of our initial public offering of stock (the IPO). Each of
the lawsuits is based on the allegations that the Companys registration
statement on Form S-1, filed with the Securities and Exchange Commission
(SEC) in connection with the IPO, contained untrue statements of material
fact and omitted to state facts necessary to make the statements made not
misleading by failing to disclose that the underwriters had received
additional, excessive and undisclosed commissions from, and had entered into
unlawful tie-in and other arrangements with, certain customers to whom they
allocated shares in the IPO. Plaintiffs have asserted claims against the
Company and the D&Os pursuant to Sections 11 and 15 of the Securities Act of
1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and
Rule 10b-5 promulgated by the SEC thereunder. The plaintiffs seek an
undisclosed amount of damages, as well as pre-judgment and post-judgment
interest, costs and expenses, including attorneys fees, experts fees and
other costs and disbursements. The lawsuits, along with all other lawsuits
filed against other issuers arising out of IPO allocations, have been assigned
to Judge Shira A. Scheindlin for pretrial coordination. The
complaints have been consolidated into a single action, Case No. 01-5074. As of
the filing of this annual report on Form 10-K, a consolidated complaint had not
been filed or designated, and the Company is not required to file answers or
other responsive pleadings at this time.




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

On October 30, 2001, a Special Meeting of Stockholders was held at which the
stockholders of the Company approved and ratified the issuance of the Series G
Preferred and the warrants issued in connection therewith. The vote was
34,641,173 shares voted for approval, 339,338 shares voted against approval,
with 34,286 shares abstaining.




PART II




Item 5.Market for Registrants Common Equity and Related Stockholder Matters

The Companys Common Stock is traded on the Nasdaq National Market under the
symbol ZTEL.

The following table sets forth, for the periods indicated, the range of high
and low closing sale prices for the Common Stock, as reported on the Nasdaq
National Market since trading began on December 15, 1999 in connection with the
Companys initial public offering, under the symbol ZTEL:

|                                        |  |      |       |     |  |   |       | 
|--------------------------------------- |  | ---- | ----- | --- |  | - | ----- | 
|                                        |  | High |       | Low
|                                        |  |      |       |    
|FISCAL YEAR 1999:                       |  |      |       |     |  |   |       | 
|Fourth Quarter (from December 15, 1999) |  | $    | 42.38 |     |  | $ | 33.13 | 
|                                        |  |      |       |     |  |   |       | 
|FISCAL YEAR 2000:                       |  |      |       |     |  |   |       | 
|First Quarter                           |  | $    | 47.25 |     |  | $ | 25.81 | 
|Second Quarter                          |  | $    | 41.63 |     |  | $ | 11.00 | 
|Third Quarter                           |  | $    | 15.13 |     |  | $ | 7.13  | 
|Fourth Quarter                          |  | $    | 9.63  |     |  | $ | 3.44  | 

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|                                       |  |   |      |  |  |   |      | 
|-------------------------------------- |  | - | ---- |  |  | - | ---- | 
|FISCAL YEAR 2001:                      |  |   |      |  |  |   |      | 
|First Quarter                          |  | $ | 6.94 |  |  | $ | 3.63 | 
|Second Quarter                         |  | $ | 4.45 |  |  | $ | 1.40 | 
|Third Quarter                          |  | $ | 1.65 |  |  | $ | 0.78 | 
|Fourth Quarter                         |  | $ | 1.95 |  |  | $ | 0.80 | 
|                                       |  |   |      |  |  |   |      | 
|FISCAL YEAR 2002:                      |  |   |      |  |  |   |      | 
|First Quarter (Through March 26, 2002) |  | $ | 2.90 |  |  | $ | 1.31 | 

HOLDERS

On March 26, 2002, the last reported sales price of the Common Stock on the
Nasdaq National Market was $1.90 per share. As of March 26, 2002, there
were approximately 233 holders of record of the Common Stock.

DIVIDENDS

We have not paid dividends on our common stock since our inception and do not
intend to pay any cash dividends for the foreseeable future but instead intend
to retain earnings, if any, for the future operation and expansion of our
business. Any determination to pay dividends in the future will be at the
discretion of our Board of Directors and will be dependent upon our results of
operations, our financial condition, restrictions imposed by applicable law and
other factors deemed relevant by the Board of Directors. In addition, our
ability to pay cash dividends is limited by provisions of our Series D, E, and
G Convertible Preferred Stock, which have dividend preferences over our common
stock. In 2000, we paid a $0.9 million cash dividend on the Series D
Convertible Preferred Stock.

RECENT SALES OF UNREGISTERED SECURITIES

On July 5 and August 3, 2001, we sold an aggregate of 175 shares of $0.01 par
value Series G Junior Convertible Preferred Stock, (the
"Series G Preferred") and
warrant (the Warrants) for the purchase of 3,000,000 shares of our common
stock, for aggregate proceeds of $17.5 million. We claim an exemption from
registration under Section 4(2) of the Securities Act of 1933 because the
transaction was by an issuer and did not involve a public offering.

The Series G Preferred is initially convertible into 11,739,970 shares of
Common Stock. The Warrants are initially exercisable at an exercise price of
$0.01 per share. The conversion rates of the Series E Preferred and the
exercise price of the Warrants are subject to adjustment upon the occurrence of
certain events that would cause dilution in the ownership of the holders of the
Series G Preferred and the Warrants.




Item 6. Selected Consolidated Financial Data

The following selected historical consolidated financial data has been derived
from our consolidated financial statements and should be read in conjunction
with the financial statements, related notes and other financial information
contained in this document. You should also read Managements Discussion and
Analysis of Financial Condition and Results of Operations, contained later in
this document. Historical results are not necessarily indicative of future
results.

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|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                  |         |  
|-------------------------------------------------- | ------------------------------ | ------------------------------------------------------------------------------- | ---------- | ----------------------------------------------- | -------- | -------------------- | ---------- | ------- | -------- | ---- | ---------- | ------ | ------- | - | --------- | ---------------- | ------- | -
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           | Period          
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           | January 15, 1998
|                                                   |                                |                                                                                 |            | Years Ended December 31,                        |          | (Inception)         
|                                                   |                                |                                                                                 |            |                                                 |          | through December 31,
|                                                   |                                |                                                                                 |            | 2001                                            |          | 2000                 |            | 1999    |          | 1998
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |     
|                                                   |                                |                                                                                 |            | (In thousands, except share and per share data)
|Revenues                                           |                                | $                                                                               | 275,897    |                                                 |          | $                    | 177,668    |         |          | $    | 6,615      |        |         | $ | 140       |                 
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|Operating expenses:                                |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|                                                   | Network operations             |                                                                                 |            | 155,164                                         |          |                      |            | 107,077 |          |      |            | 6,518  |         |   |           | 382              |        
|                                                   | Sales and marketing            |                                                                                 |            | 31,243                                          |          |                      |            | 45,018  |          |      |            | 8,898  |         |   |           | 2,201            |        
|                                                   | Research and development       |                                                                                 |            | 8,935                                           |          |                      |            | 8,276   |          |      |            | 3,562  |         |   |           | 4,728            |        
|                                                   | General and administrative (4) |                                                                                 |            | 147,172                                         |          |                      |            | 91,330  |          |      |            | 16,493 |         |   |           | 4,718            |        
|                                                   | Impairment of assets (3)       |                                                                                 |            | 59,247                                          |          |                      |            |        |          |      |            |       |         |   |           |                 |        
|                                                   | Depreciation and amortization  |                                                                                 |            | 23,277                                          |          |                      |            | 17,166  |          |      |            | 4,372  |         |   |           | 1,283            |        
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|                                                   |                                | Total operating expenses                                                        |            |                                                 | 425,038  |                      |            |         | 268,867  |      |            |        | 39,843  |   |           |                  | 13,312  |  
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|                                                   |                                | Operating loss                                                                  |            |                                                 | (149,141 | )                    |            |         | (91,199  | )    |            |        | (33,228 | ) |           |                  | (13,172 | )
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|Nonoperating income (expense):                     |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|                                                   | Interest and other income      |                                                                                 |            | 6,862                                           |          |                      |            | 5,475   |          |      |            | 608    |         |   |           | 228              |        
|                                                   | Interest and other expense     |                                                                                 |            | (3,789                                          | )        |                      |            | (2,313  | )        |      |            | (3,351 | )       |   |           | (178             | )      
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|                                                   |                                | Total nonoperating income (expense)                                             |            |                                                 | 3,073    |                      |            |         | 3,162    |      |            |        | (2,743  | ) |           |                  | 50      |  
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|                                                   |                                | Net loss                                                                        |            |                                                 | (146,068 | )                    |            |         | (88,037  | )    |            |        | (35,971 | ) |           |                  | (13,122 | )
|                                                   |                                | Less mandatorily redeemable convertible
preferred stock dividends and accretion |            |                                                 | (15,059  | )                    |            |         | (3,644   | )    |            |        | (1,654  | ) |           |                  | (190    | )
|                                                   |                                | Less deemed dividend related to beneficial
conversion feature                   |            |                                                 | (9,356   | )                    |            |         | (20,027  | )    |            |        |        |   |           |                  |        |  
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|                                                   |                                | Net loss attributable to common stockholders                                    |            | $                                               | (170,483 | )                    |            | $       | (111,708 | )    |            | $      | (37,625 | ) |           | $                | (13,312 | )
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|Weighted average common shares outstanding         |                                |                                                                                 | 33,908,374 |                                                 |          |                      | 33,066,538 |         |          |      | 15,099,359 |        |         |   | 6,554,499 |                 
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|Basic and diluted net loss per share               |                                | $                                                                               | (5.03      | )                                               |          | $                    | (3.38      | )       |          | $    | (2.49      | )      |         | $ | (2.03     | )               
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|Consolidated Balance Sheet Data                    |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|Cash and cash equivalents (2) (5)                  |                                |                                                                                 | 18,892     |                                                 |          |                      | 46,650     |         |          |      | 101,657    |        |         |   | 7,973     |                 
|Working capital (deficit)                          |                                |                                                                                 | (11,983    | )                                               |          |                      | 59,245     |         |          |      | 95,315     |        |         |   | 3,328     |                 
|Total assets                                       |                                |                                                                                 | 116,737    |                                                 |          |                      | 246,461    |         |          |      | 137,677    |        |         |   | 20,274    |                 
|Total debt                                         |                                |                                                                                 | 15,766     |                                                 |          |                      | 20,417     |         |          |      | 14,134     |        |         |   | 724       |                 
|Mandatorily convertible redeemable preferred stock |                                |                                                                                 | 112,570    |                                                 |          |                      | 84,585     |         |          |      |           |        |         |   | 15,154    |                 
|Total stockholders equity (deficit)               |                                |                                                                                 | (67,172    | )                                               |          |                      | 89,100     |         |          |      | 114,378    |        |         |   | (6        | )               
|                                                   |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|Other Financial Data                               |                                |                                                                                 |            |                                                 |          |                      |            |         |          |      |            |        |         |   |           |                 
|EBITDA (1)                                         |                                |                                                                                 | (125,864   | )                                               |          |                      | (74,033    | )       |          |      | (28,856    | )      |         |   | (11,889   | )               
|Net cash used in operating activities              |                                |                                                                                 | (21,846    | )                                               |          |                      | (96,862    | )       |          |      | (32,681    | )      |         |   | (7,769    | )               
|Net cash used in investing activities              |                                |                                                                                 | (15,615    | )                                               |          |                      | (40,602    | )       |          |      | (5,182     | )      |         |   | (11,393   | )               
|Net cash provided by financing activities          |                                |                                                                                 | 9,701      |                                                 |          |                      | 82,455     |         |          |      | 131,547    |        |         |   | 27,135    |                 



---

|(1) |  | EBITDA consists of earnings
before deducting interest, income taxes,
depreciation and amortization. While not a measure under accounting
principles generally accepted in the United States of America (GAAP),
EBITDA is a measure commonly used in the telecommunications industry
and is presented to assist in understanding our operating results.
Although EBITDA should not be construed as a substitute for operating
income (loss) determined in accordance with GAAP, it is included herein
to provide additional information with respect to our ability to meet
future debt service, capital expenditures and working capital
requirements. The calculation of EBITDA does not include our
commitments for capital expenditures and payment of debt and should not
be deemed to represent our available funds. See Managements
Discussion and Analysis of Financial Condition and Results of
Operations for a discussion of the financial operations and liquidity
of the Company as determined in accordance with GAAP.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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|   
|---
|(2)
|   
|(3)
|   
|(4)
|   
|(5)




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

You should read the following discussion together with the Selected
Consolidated Financial Data, financial statements and related notes included
in this document. This discussion contains forward-looking statements that
involve risks and uncertainties. Our actual results may differ materially from
those projected in the forward-looking statements as a result of certain
factors, including, but not limited to, those discussed in Item 1. Business,
as well as Cautionary Statements Regarding Forward-Looking Statements, Risks
Related to our Financial Condition and our Business and Risks Related to our
Industry, below, and other factors relating to our business and us that are
not historical facts. Factors that may affect our results of operations
include, but are not limited to, our limited operating history and cumulative
losses, uncertainty of customer demand, rapid expansion, potential software
failures and errors, potential network and interconnection failure, dependence
on local exchange carriers, dependence on third party vendors, dependence on
key personnel, uncertainty of government regulation, legal and regulatory
uncertainties, and competition. We disclaim any obligation to update
information contained in any forward-looking statement.

OVERVIEW

We are an emerging provider of advanced, integrated telecommunications services
targeted to residential and small business subscribers. For management
purposes, we are organized into one reportable operating segment. We offer
local and long distance telephone services in combination with enhanced
communication features accessible through the telephone or the Internet. The
nature of our business is rapidly evolving, and we have a limited operating
history.

History of Operations

We were founded in January of 1998. In our first
year of operations, we focused
primarily on research and development activities, recruiting personnel,
purchasing operating assets, and developing our service offerings and marketing
plans. In the fourth quarter of 1998, we launched our first service offering
composed of an access card to make long-distance calls from any phone coupled
with enhanced services, such as voice mail, find-me, and community messaging.
In 1998 our revenues totaled $0.1 million. During June of 1999 we launched our
primary service offering Z-Line Home Edition (currently called Z-LineHOME) in
New York. This is our bundled telecommunications service providing integrated
local, long-distance and enhanced services targeted at residential customers.
Our revenues for 1999 increased to $6.6 million. On December 15, 1999, we
filed our initial public offering of 6.9 million shares. This offering
resulted in net proceeds to us of approximately $109.1 million. This offering
provided us with the opportunity, at the potential expense of profitability, to
accelerate our investments in the building of our network, continued research
and development, sales and marketing, and professional services and general and
administrative infrastructure. These investments lead to our revenue growing
to $177.7 million, a 2,592% increase over the prior year. Nevertheless, these
investments also significantly increased our operating and cash expenditures.
This growth was slowed during 2001 as we moved our focus from growth to
profitability. We

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focused on lowering customer acquisition costs, improving operating
efficiencies, and attracting and maintaining a higher quality customer. We
also experienced a reduction in overall head count in 2001 through a workforce
reduction, attrition and the sale of the majority of the operations and assets
of the telemarketing centers that we acquired in 2000. These initiatives
resulted in a charge of $29.9 million relating to the write-off of certain
accounts receivables and $59.2 million for the impairment of assets relating to
the sale of telemarketing centers. In 2001, we had revenues of $275.9 million
and incurred a net loss of $146.1 million compared to a net loss of $88.0 million in
2000. We believe that the improvements we have made in 2001 may result in the
achievement of positive EBITDA and cash flows, on a quarterly basis, in 2002.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principals generally accepted in
the United States. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an on-going basis, we evaluate our critical accounting
policies and estimates, including those related to revenue recognition, network
operations expense, valuation of accounts receivable, property, plant
and equipment, long-lived assets, intangible assets, and contingencies. We
base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results
may differ materially from these estimates under different assumptions or
conditions.

We believe the following critical accounting policies affect the more
significant judgments and estimates used in the preparation of our consolidated
financial statements.



| |  |  | Revenue Recognition. Revenues are recognized when earned. Revenue
related to long distance and carrier access service charges are billed
monthly in arrears and the associated revenues are recognized during
the month of service. Subscription services are billed monthly in
advance and we recognize revenues for this service ratably over the
service period. We operate in a heavily regulated industry; therefore,
our pricing is subject to both state and federal regulatory commission
oversight. Such oversight could result in changes to the amount we
bill our customers in current and future periods.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Network Operations Expense.
Network operations expenses are primarily
charges from the Incumbent Local Exchange Carriers (ILECs) for the
leasing of their lines, utilizing the unbundled network element
platform pricing (UNE-P), made available to us as a result of the
Telecommunication Act of 1996. This pricing is subject to both state and federal
oversight and therefore, our pricing is subject to change. This change
could have a material impact on our business model.                                                                                                                                
|
| |  |  | Valuation of Accounts Receivable. A considerable amount of
judgment is required when we assess the ultimate realization of
receivables, including assessing the probability of collection and the
current credit-worthiness of our customers. We have recorded
significant changes in our bad debt reserves in recent periods due to
the occurrence of new events, the acquiring of new information, and the
gaining of additional experience. This analysis is performed
regularly.                                                                                                                                  
|
| |  |  | Property, Plant and Equipment. Changes in technology or changes in
the intended use of properly, plant and equipment may cause the
estimated period of use or the value of these assets to change. We
utilize straight-line depreciation for property and equipment. We
perform an annual analysis to confirm the appropriateness of estimated
economic useful lives for each category of current property, plant and
equipment. Estimates and assumptions used in both setting depreciable
lives and testing for recoverability require both judgment and
estimates.                                                 
|
| |  |  | Long-Lived and Intangible Assets. We periodically evaluate
long-lived and intangible assets, through the use of discounted cash
flow projections, for potential impairment indicators. Additionally,
long-lived assets are reviewed for impairment whenever events or
changes in circumstances indicate that their                                                                                                                                                                                                                                                                                                    

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| |   |  | carrying amounts may not be recoverable. Our judgments regarding the
existence of impairment indicators are based on legal factors, market
conditions, and operational considerations. Future events could cause us
to conclude that impairment indicators exist and that goodwill and other
intangible assets associated with our acquired businesses are impaired.
For fiscal years beginning in 2002, the methodology for assessing
potential impairments of intangible asset changes as a result of
Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets. Goodwill will no longer be amortized monthly, but
instead will be subject to impairment tests at least annually.                                                                                                                                                                                    
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Contingencies. We have disputed billings and access charges to and
from inter-exchange carriers (IXCs) and ILECs. We are also subject to
proceedings, lawsuits and other claims related to lawsuits
and other legal and regulatory proceedings that arise in the ordinary
course of business. We are required to assess the likelihood of any
adverse judgments or outcomes to these matters as well as potential
ranges of provable losses. A determination of the amount of loss
accrual required, if any, for these contingencies are made after
careful analysis of each individual issue. We consult with legal
counsel and other experts where necessary in connection with our
assessment of any contingencies.
The required accrual may change in the future due to new developments
in each matter or changes in approach such as a change in settlement
strategy in dealing with these matters.

Acquisition of Touch 1 Communications, Inc. and Subsidiaries

We completed the acquisition of Touch 1 Communications, Inc. (Touch 1), on
April 14, 2000. The purchase price of Touch 1 consisted of 1.1 million shares
of our common stock and $9.0 million in cash. Touch 1 provided us with
employees in sales, provisioning, and customer service. We used the purchase
accounting method for our acquisition of Touch 1. Therefore, our discussions
of the results of operations and liquidity and capital resources do not include
any discussions regarding Touch 1 prior to our acquisition of Touch 1, which is
treated as being closed for accounting purposes, on April 1, 2000. This
treatment is in accordance with the adoption of the purchase method of
accounting. As a result of our purchase of Touch 1, we recorded goodwill of
$58.6 million and intangible assets related to customer lists of $9.2 million
on April 1, 2000. During the second quarter of 2001, we recorded a $54.9
million impairment of assets relating to the goodwill acquired from Touch 1.
See the Impairment of Assets discussion in the Results of Operations for
further details.

RESULTS OF OPERATIONS

Year Ended December 31, 2001 Compared to Year Ended December 31, 2000

Revenues.Revenues increased by $98.2 million to $275.9 million for the year
ended December 31, 2001, compared to $177.7 million last year. The increase is
attributable to the average Z-LineHOME customer count of 297,000 for the year
ended December 31, 2001, compared to 190,000 for the same period in the prior
year. Touch 1 contributed $22.9 million of revenue for the year ended December
31, 2001 compared to $29.7 million last year. The following tables outline the
approximate number of subscriber lines for Z-LineHOME and Touch 1 (1+) long
distance services as of the end of the period:

|                                    |  |                   |         |                   |  |  |         | 
|----------------------------------- |  | ----------------- | ------- | ----------------- |  |  | ------- | 
|Type of Service                     |  | December 31, 2001 |         | December 31, 2000
|                                    |  |                   |         |                  
|Z-LineHOME                          |  |                   | 254,000 |                   |  |  | 340,000 | 
|Touch 1 (1+) Long Distance Services |  |                   | 160,000 |                   |  |  | 255,000 | 

The reduction in lines during 2001 was a result of our effort to slow growth
while eliminating poor paying customers and increasing the stringency of customer acceptance.

Our primary service offering, Z-LineHOME, which
accounted for 91.4% of our
total revenues in 2001 compared to 83.3% last year, is available in 38
states. We expect Z-LineHOME to continue to increase as a percentage of
revenue relative to our Touch 1 (1+) Long Distance Services but decrease as a
percentage of total revenue as we expect growth in our wholesale service
offerings. Our Z-LineHOME revenues were primarily derived from the
following ten
states shown in the below table:

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|              |  |                     |     |      |  |  |     |  
|------------- |  | ------------------- | --- | ---- |  |  | --- | -
|              |  | Percentage of
Total
|              |  | Z-Line Home
Revenue
|              |  | 2001                |     | 2000
|              |  |                     |     |     
|California    |  |                     | 2   | %    |  |  | 0   | %
|Georgia       |  |                     | 5   | %    |  |  | 2   | %
|Illinois      |  |                     | 5   | %    |  |  | 0   | %
|Massachusetts |  |                     | 2   | %    |  |  | 3   | %
|Maryland      |  |                     | 2   | %    |  |  | 0   | %
|Michigan      |  |                     | 9   | %    |  |  | 0   | %
|New York      |  |                     | 53  | %    |  |  | 69  | %
|Pennsylvania  |  |                     | 9   | %    |  |  | 7   | %
|Texas         |  |                     | 10  | %    |  |  | 17  | %
|Virginia      |  |                     | 2   | %    |  |  | 0   | %
|All others    |  |                     | 1   | %    |  |  | 2   | %
|              |  |                     |     |      |  |  |     |  
|Total         |  |                     | 100 | %    |  |  | 100 | %
|              |  |                     |     |      |  |  |     |  

Network Operations.Network operations expense increased by $48.1 million to
$155.2 million for the year ended December 31, 2001, compared to $107.1 million
last year. Our consolidated gross margin percentage increased to 43.8% for the
year ended December 31, 2001, compared to 39.7% for the prior year. Our network
operations expense primarily consists of fixed and variable transmission
expenses for interconnection agreements with incumbent local exchange carriers
(ILECs), service level agreements with inter-exchange carriers (IXCs), and
transmission services based on tariffed arrangements. The increase in network
operation expenses and improved margins is the result of having an overall
higher average number of subscribers in service for the year ended 2001
compared to last year.

The New York Public Service Commission is imposing a rate reduction to the
UNE-P pricing, effective March 1, 2002. This reduction to UNE-P
rates in New York, the state in which we have our largest concentration of
customers, is expected to lower our overall cost to provide services to
customers in New York. This reduction is expected to result in an increased
gross margin percentage during 2002. In addition to this reduction as of March
1, 2002 we expect a retroactive reduction of rates that will result in a credit
applied to future services for amounts already paid for UNE-P in the
state of New
York. The amount of the
retroactive reduction has yet to be fully determined.

Sales and Marketing.Sales and marketing expense decreased $13.8 million to
$31.2 million for the year ended December 31, 2001, compared to $45.0 million
last year. The sales and marketing expense primarily consists of telemarketing,
direct mail, brand awareness advertising, agent commissions and salaries and
benefits paid to employees engaged in sales and marketing activities.

We utilized radio, billboard, and television
advertising in 2001 because of their
lower acquisition cost per subscriber compared to telemarketing and direct mail
solicitations, which had driven our growth during 2000. Our focus on lower
acquisition cost coupled with our change of our customer acceptance
policies and
reduced growth
objectives during 2001 resulted in a decrease of $10.1 million of sales
and marketing expense. The remaining decrease in sales and marketing expense
is primarily attributable to the sale and closure of substantially all of our telemarketing
centers in Minot, North Dakota and Canada as of June 30, 2001. This decrease in
marketing has contributed to the overall decreased of 86,000 lines during
2001.

We expect to continue to focus our sales and marketing efforts to lower
acquisition costs per subscriber economics during 2002. We expect to increase
marketing during the first quarter of 2002 as we begin shifting toward a more
controlled growth in subscribers for 2002. We will continue to build our
overall awareness of the Z brand, and continue to explore alliances and
ventures with other companies. We expect sales and marketing expense to
decrease further in 2002 as we utilize more efficient marketing approaches and
realize the benefit from the sale and closure of our telemarketing centers for a full
fiscal year. The addition of our wholesale business in 2002 may also reduce
sales and marketing expense as this revenue stream will not require increased
sales and marketing efforts.

Research and Development.Research and development expense increased $0.6
million to $8.9 million for the year ended December 31, 2001, compared to $8.3
million last year. Our research and development expense consists
primarily of salaries and benefits paid to employees engaged in research and
development activities and outside third party development costs.

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The enhancement of our current service offerings and the development of new
products and services have contributed to increased research and development
costs for the year ended December 31, 2001. We focused on improving operating
efficiency and the overall customer experience during the second half of 2001.
The research and development staff supported our focus on efficiency by
leveraging technology and developing new technology to improve our
operating results. We launched our small business offering during 2001. This
offering is currently in the testing phase but is expected to begin generating
revenues in mid-to-late 2002. We also introduced our beta version of voice
recognition software during 2001.

We expect that research and development will continue to play an important role in
our operations, customer experience and enhanced service offerings during 2002.
Research and development will increase in 2002 as we focus on enhancing and
developing our small business and wholesale business initiatives and work to
integrate voice recognition into our offerings. We also are developing our
on-line capabilities during 2002 to improve our competitive position, generate
new revenue streams and provide customers with an easy sign-up process for our
services and also to allow the customers to manage their accounts by making
payments, changing features and receiving notifications through the web. These
developments should decrease our general and administrative cost per
subscriber. We plan to continue to develop new services and utilize technology to
improve our operational efficiencies and profitability.

General and Administrative.General and administrative expense increased $55.9
million to $147.2 million for the year ended December 31, 2001, compared to
$91.3 million last year. General and administrative expense primarily consists
of employee salaries, temporary services, bad debt expense, billing and
collection expense, occupancy costs, and provisioning costs.

The increase in general and administrative expense primarily relates to the
write-off of accounts receivable that resulted in $29.9 million of additional
bad debt expense recorded during the second quarter of 2001. Excluding the
$29.9 million of bad debt expense, general and administrative expense was 43%
of revenue compared to 51% for the years ended December 31, 2001 and 2000,
respectively. This reduction as a percentage of revenue is the result of
various cost control measures implemented during 2001, to support our focus on
improved subscriber economics rather than growth, as well as an increased
utilization of fixed costs within our business.

We anticipate general and administrative expenditures will continue to increase
in the future to support our expanding service offerings and our expected
increase in lines during 2002. We will continue to evaluate our operations for
efficiencies and our employee staffing requirements as they relate to increased
efficiency, and we expect to see further reductions of general and
administrative expense as a percentage of revenue. This reduction is necessary for us to achieve profitability and generate positive cash flow in the second half
of 2002.

Impairment of Assets

We recorded a $59.2 million expense related to impaired assets in the second
quarter of 2001.

As a result of managements decision in the second quarter to reduce
telemarketing efforts, a majority of the operations and assets of telemarketing
centers acquired from Touch 1 were either voluntarily closed or sold. On June
30, 2001 the telemarketing centers sold accounted for approximately $1.0
million in property, plant and equipment. For these assets, we received 270,000
shares of preferred stock of the privately held acquiror and a note
receivable of approximately $0.5 million. The loss recorded on this transaction
equated to approximately $1.0 million.

As a result of the decision to reduce telemarketing efforts noted above and the
subsequent transactions, management performed an assessment of the value of the
intangible assets recorded in the Touch 1 acquisition, in accordance with SFAS
No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of. In the second quarter 2001, it was determined that
undiscounted future cash flows over the remaining amortization period of
certain intangible assets indicated that the value assigned to the intangible
assets might not be recoverable. Therefore, the Company undertook an effort to
determine the amount of expense to be recorded relating to the impairment.

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The carrying value of the goodwill and identifiable
intangible assets recorded on our
books approximated $61.7 million prior to the impairment analysis. We
calculated the fair value of goodwill by performing a discounted cash flow
analysis related to the remaining assets acquired in the Touch 1 purchase. As
we determined that we would effectively cease any telemarketing efforts in the
future, the sole remaining assets from the Touch 1 purchase were certain
amounts of property, plant and equipment and intangible assets (consisting of
customer lists and goodwill) acquired in the Touch 1 transaction. Assuming an
attrition rate of 4.5% and a discount rate of 17.5%, it was determined that the
remaining operations acquired from Touch 1 have a liquidation value which
approximates the identifiable intangible assets associated with the carrying
value of the customer lists acquired from Touch 1. At June 30, 2001, the
carrying value of the identifiable intangible assets associated with the
customer lists was approximately $6.8 million. Therefore, we recorded a loss of
$54.9 million, the difference between the carrying value of all intangibles and
the carrying value of the customer lists.

We recorded an additional $4.3 million charge associated with the impairment of
assets, composed of $3.0 million relating to unrealizable software and
development projects, $0.9 million of a worthless telemarketing property and
equipment, and $0.4 million of securities deemed to be worthless.

We had $5.9 million of intangible assets relating to customer lists recorded as
of December 31, 2001.

Depreciation and Amortization.Depreciation and amortization expense increased
$6.1 million to $23.3 million for the year ended December 31, 2001, compared to
$17.2 million last year. The increase in depreciation and amortization is
primarily a result of customer growth over the last few years. We had more fixed assets
in service during 2001. We anticipate additional purchases of computer
equipment, switching equipment, furniture and leasehold improvements, which will contribute to increased depreciation and amortization
expense for the year ended December 31, 2002.

Interest and Other Income.Interest and other income increased $1.4 million to
$6.9 million for the year ended December 31, 2001, compared to $5.5 million
last year. Interest and other income consists of interest charged to our
Z-LineHOME customers for not paying their bills on-time and income from
interest earned from our cash balance and any gains from the sale of
investments or securities. The increase for 2001 was primarily due to an overall
average of more customers in service in 2001 compared to 2000 resulting in
larger late payment fees being assessed to customers.

Interest and Other Expense.Interest and other expense increased $1.5 million
to $3.8 million for the year ended December 31, 2001, compared to $2.3 million
last year. Our interest expense is a result of the interest charged related to
our RFC Capital Corporation (RFC) accounts receivable agreement, capital leases and other debt
obligations. The increased interest expense relates to the utilization of our
accounts receivable arrangement with RFC Capital, LLC during 2001. We
anticipate interest expense to increase in the future as a result of the
potential borrowing of money to support operations through new funding sources
and the financing of various capital expenditures necessary to grow our
business in 2002. We anticipate utilizing the RFC accounts receivable
agreement during the
remainder of 2002.

Income Tax Expense.No provision for federal or state income taxes has been
recorded due to the full valuation allowance recorded against the deferred tax
asset for the years ended December 31, 2001 and 2000.

Net Loss.Our net loss increased $58.1 million to $146.1 million for the year
ended December 31, 2001, compared to $88.0 million in the prior year. This
increase was due primarily to the increases in expenses described above.

Net Loss Attributable to Common Stockholders.Our net loss attributable to
common stockholders increased $58.8 million to $170.5 million for the year
ended December 31, 2001, compared to $111.7 million for the same period in the
prior year. This increase was due primarily to the increases in expenses
described above and the issuance of the Series D, E and G
Preferred shares. In
conjunction with the Series D, E and G Preferred, we incurred an aggregate of
$15.1 million of non-cash charges relating to preferred stock
dividends and
accretion and an aggregate of $9.4 million of a deemed dividend
relating to a beneficial conversion feature. This compared to $3.6 million of
preferred stock dividends and accretion and $20.0 million of a deemed dividend
for the year ended December 31, 2000.

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In November 2000, the Emerging Issues Task Force 00-27 Application of Issue
No. 98-5 to Certain Convertible Instruments required that all beneficial
conversions be calculated using the accounting conversion price method. The
Company recorded a $12.6 million cumulative catch-up adjustment, included in
the $20.0 million beneficial conversion feature, as a result of the Securities and
Exchange Commission requiring retroactive application of this method.

During 2001, we recorded a deemed dividend of
$1.1 million, which resulted from
the value assigned to the warrants and a beneficial conversion feature
associated with the Series G Preferred transaction. This deemed dividend was
originally accreted over an expected life through December 31, 2001 (the
earliest redemption date). Once shareholder approval was obtained on October
31, 2001, the remaining balance of $1.2 million began to be accreted over the
remaining 5-year redemption period that started at the date of grant. As a
result of the Series G Preferred transaction certain anti-dilution clauses in
the Series D Preferred stock agreement triggered an additional deemed dividend
relating to a beneficial conversion feature that was accreted immediately in
the amount of $7.8 million.

EBITDA.Many securities analysts use the measure of earnings before deducting
interest, income taxes, depreciation and amortization, also commonly referred to as
EBITDA, as a way of evaluating our financial performance. EBITDA is not a
measure under accounting principles generally accepted in the United States of
America (GAAP), is not meant to be a replacement for GAAP and should not be
considered an alternative to net income as a measure of performance or to cash
flows as a measure of liquidity. We have included EBITDA data because it is a
measure commonly used in the telecommunications industry and is presented to
assist in understanding our operating results. Our negative EBITDA increased
$51.9 million to $125.9 million for the year ended December 31, 2001, compared
to $74.0 million last year. We expect to achieve positive EBITDA on a monthly
basis during late second quarter or early third quarter of 2002. The
generation of positive
EBITDA will primarily be attributed to increases in subscribers, operating
efficiencies, and new revenue streams.

Year Ended December 31, 2000 Compared to Year Ended December 31, 1999

Revenue.Revenue increased by $171.1 million to $177.7 million for the year
ended December 31, 2000, compared to $6.6 million last year. The increase is
attributable to the average Z-LineHOME customer count of 190,000 for the year
ended December 31, 2000, compared to 20,000 for the same period in the prior
year. The purchase of Touch 1 provided an additional increase in revenue of
$29.7 million from its existing (1+) long-distance offering for the period April
1, 2000 through December 31, 2000. The following tables outline the approximate
number of subscriber lines for Z-LineHOME, Z-Line Anywhere and Touch 1 (1+)
long distance services as of the end of the period:

|                                                        |  |                   |         |                   |  |  |        | 
|------------------------------------------------------- |  | ----------------- | ------- | ----------------- |  |  | ------ | 
|Type of Service                                         |  | December 31, 2000 |         | December 31, 1999
|                                                        |  |                   |         |                  
|Z-LineHOME                                              |  |                   | 340,000 |                   |  |  | 40,000 | 
|Z-Line Anywhere and Touch 1 (1+) Long Distance
Services |  |                   | 255,000 |                   |  |  | 26,000 | 

Network Operations.Network operations expense increased by $100.6 million to
$107.1 million for the year ended December 31, 2000, compared to $6.5 million
in the prior year. The gross margin increased to 39.7% for the year ended
December 31, 2000, compared to 1.46% for the prior year. The network operations
expense primarily consists of fixed and variable transmission expenses for
interconnection agreements with incumbent local exchange carriers (ILECs),
service level agreements with inter-exchange carriers (IXCs), and transmission
services based on tariffed arrangements. The increase in network operation
expense and improved margins is the result of our subscriber growth.

Sales and Marketing.Sales and marketing expense increased $36.1 million to
$45.0 million for the year ended December 31, 2000, compared to $8.9 million in
the prior year. The sales and marketing expense primarily consists of
telemarketing, direct mail, brand awareness advertising, agent commission and
salaries and benefits paid to employees engaged in sales and marketing
activities.

The increase in sales and marketing expense is attributable to entering new
states more rapidly than anticipated, which drove increased telemarketing,
direct mail efforts, and brand awareness. We also launched a marketing campaign
for our City of America service that provides unlimited calling between
Z-LineHOME members, for an
additional monthly fee. This campaign was introduced in Texas and has been
rolled out to all of the other states in which we offer Z-LineHOME service.

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Research and Development.Research and development expense increased $4.7
million to $8.3 million for the year ended December 31, 2000, compared to $3.6
million in the prior year. Our research and development expense consist
primarily of salaries and benefits paid to employees engaged in research and
development activities and outside third party development costs.

The enhancement of our current product offerings, development of new products
and services and internal use software development have contributed to
increased research and development costs for the year ended December 31, 2000.
We also introduced Z-Alerts during 2000 and will continue to develop new
product offerings.

Research and development is an important part of our operations and customer
support. We built an electronic gateway that was substantially
completed during
December 2000 that increased our efficiency to provision and perform other
services for our customers in 2001. This technology improvement led
to a workforce
reduction in 2001 that decreased some payroll related general and
administrative expenses.

General and Administrative.General and administrative expense increased $74.8
million to $91.3 million for the year ended December 31, 2000, compared to
$16.5 million in the prior year. Increased expenses in employee salaries,
temporary services, bad debt expense, billing and collection expense, occupancy
costs, and provisioning costs were necessary to support the growth we
experienced.

The acquisition of Touch 1 and an increase of approximately 300,000 net
subscriber lines in 2000 contributed to increased general and administrative
expense. We increased our capacity for back-office operations to provide for
our growth, and introduced our Z-LineHOME offering to eleven new states in
2000. The later than expected implementation of our electronic gateway and the
overall increase in bad debts from increased customers were all contributing
factors to our increased general and administrative expenses.

Depreciation and Amortization.Depreciation and amortization expense increased
$12.8 million to $17.2 million for the year ended December 31, 2000, compared
to $4.4 million in the prior year. The increase in depreciation and
amortization was the result of the acquisition of Touch 1 and our purchases of
equipment. Intangible assets, which were composed of $9.2 million and $58.6
million allocated to customer lists and goodwill, respectively, and amortized
over 5 and 20 year lives, respectively, resulted in amortization
expense of $3.6
million for the year ended December 31, 2000. In addition, the purchase of
computer equipment, switching equipment, furniture and leasehold improvements
required to maintain our growth and expand our operations also contributed to
the increased depreciation and amortization expense for the year ended December
31, 2000.

Interest and Other Income.Interest and other income increased $4.9 million to
$5.5 million for the year ended December 31, 2000, compared to $0.6 million in
the prior year. Interest and other income consists of income from interest
earned from our cash balance and any gains from the sale of investments or
securities. The increase was primarily due to a $2.7 million gain on the sale
of an equity investment in 2000. The remaining increase in 2000 was a result of
larger cash reserves from our initial public offering and our Series D and E
Preferred shares offerings. We raised net proceeds of $109.1 million after
underwriting discounts and commissions in our initial public offering in late
December 1999, and net proceeds of $55.9 and $49.0 million in our Series D and
E Preferred share offerings during 2000, respectively.

Interest and Other Expense.Interest and other expense decreased $1.1 million
to $2.3 million for the year ended December 31, 2000, compared to $3.4 million
in the prior year. Our decreased interest expense was the result of
the reduced interest charged on
our capital lease and other debt obligations.

Income Tax Expense.No provision for federal or state income taxes was recorded
due to the full valuation allowance recorded against the deferred tax asset for
the year ended December 31, 2000 and 1999.

Net Loss.Our net loss increased $52.0 million to $88.0 million for the year
ended December 31, 2000, compared to $36.0 million in the prior year. This
increase was due primarily to the increases in expenses described above.

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Net Loss Attributable to Common Stockholders.Our net loss attributable to
common stockholders increased $74.1 million to $111.7 million for the year
ended December 31, 2000, compared to $37.6 million for the same period in the
prior year. This increase was due primarily to the increases in expenses
described above and the issuance of the Series D and E Preferred. In
conjunction with the Series D and E Preferred, we incurred $23.7 million of
non-cash charges relating to a deemed dividend relating to a beneficial
conversion feature and a cumulative dividends and preferred stock accretion in
the amounts of $20.0 and $3.6 million for the year ended December 31, 2000.
This compared to $1.7 and $0.2 million of preferred stock dividends and
accretion for the year ended December 31, 1999 and the period January 31, 1998
(Inception) through December 31, 1998, respectively. In November 2000, the
Emerging Issues Task Force 00-27 Application of Issue No. 98-5 to Certain
Convertible Instruments required that all beneficial conversions be calculated
using the accounting conversion price method. The Company recorded a $12.6
million cumulative catch-up adjustment, included in the $20.0 million
beneficial conversion feature, as a result of the Securities and Exchange Commission
requiring retroactive application of this method.

EBITDA.Many securities analysts use the measure of earnings before deducting
interest, taxes, depreciation and amortization, also commonly referred to as
EBITDA, as a way of evaluating our financial performance. EBITDA is not a
measure under accounting principles generally accepted in the United States of
America (GAAP), and it is not meant to be a replacement for GAAP and should not be
considered an alternative to net income as a measure of performance or to cash
flows as a measure of liquidity. We have included EBITDA data because it is a
measure commonly used in the telecommunications industry and is presented to
assist in understanding our operating results. Our negative EBITDA increased
$45.1 million to $74.0 million for the year ended December 31, 2000, compared
to $28.9 million in the prior year.

Quarterly Results of Operations

The following tables present our unaudited quarterly results of operations both
in dollar amounts and expressed as a percentage of the total revenues for 2001
and 2000. Our quarterly operating results have varied widely in the past, and
we expect that they will continue to fluctuate in the future as a result of a
number of factors, many of which are outside of our control.

You should read these tables in conjunction with our Consolidated Financial
Statements and Related Notes included elsewhere in this document. We have
prepared this unaudited information on the same basis as the audited
Consolidated Financial Statements. You should not draw any conclusions about
our future results from the results of operations for any quarter.

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Z-Tel Technologies, Inc. and Subsidiaries
Consolidated Quarterly Statements of Operations
(In thousands)
(Unaudited)



|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |        |         |  
|------------------------------ | ----------------------------- | ------------------------------------------------------------------------------- | ------ | -------- | ------ | -------- | ------ | -------- | ------ | -------- | ------ | -------- | ------- | -------- | ------- | ----- | ------- | - | ------- | ------ | ------- | - | ------- | ------ | ------- | -
|                               |                               |                                                                                 |        | 3 Months |        | 3 Months |        | 3 Months |        | 3 Months |        | 3 Months |         | 3 Months
|                               |                               |                                                                                 |        | 03.31.99 |        | 06.30.99 |        | 09.30.99 |        | 12.31.99 |        | 03.31.00 |         | 06.30.00
|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |         
|Revenues                       |                               | $                                                                               | 664    |          |        | $        | 761    |          |        | $        | 745    |          |         | $        | 4,445   |       |         | $ | 13,976  |        |         | $ | 40,157  |       
|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       
|Operating expenses:            |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       
|                               | Network operations            |                                                                                 |        | 814      |        |          |        | 978      |        |          |        | 2,039    |         |          |         | 2,687 |         |   |         | 9,830  |         |   |         | 25,137 |        
|                               | Sales and marketing           |                                                                                 |        | 1,182    |        |          |        | 666      |        |          |        | 2,112    |         |          |         | 4,938 |         |   |         | 6,819  |         |   |         | 10,635 |        
|                               | Research and development      |                                                                                 |        | 1,113    |        |          |        | 352      |        |          |        | 1,154    |         |          |         | 943   |         |   |         | 1,299  |         |   |         | 1,790  |        
|                               | General and administrative    |                                                                                 |        | 2,597    |        |          |        | 2,390    |        |          |        | 5,204    |         |          |         | 6,302 |         |   |         | 10,461 |         |   |         | 20,878 |        
|                               | Impairment of assets          |                                                                                 |        |         |        |          |        |         |        |          |        |         |         |          |         |      |         |   |         |       |         |   |         |       |        
|                               | Depreciation and amortization |                                                                                 |        | 801      |        |          |        | 863      |        |          |        | 1,085    |         |          |         | 1,623 |         |   |         | 2,088  |         |   |         | 4,404  |        
|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       
|                               |                               | Total operating expenses                                                        |        |          | 6,507  |          |        |          | 5,249  |          |        |          | 11,594  |          |         |       | 16,493  |   |         |        | 30,497  |   |         |        | 62,844  |  
|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       
|                               |                               | Operating loss                                                                  |        |          | (5,843 | )        |        |          | (4,488 | )        |        |          | (10,849 | )        |         |       | (12,048 | ) |         |        | (16,521 | ) |         |        | (22,687 | )
|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       
|Nonoperating income (expense): |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       
|                               | Interest
and other income     |                                                                                 |        | 118      |        |          |        | 114      |        |          |        | 87       |         |          |         | 289   |         |   |         | 1,286  |         |   |         | 455    |        
|                               | Interest
and other expense    |                                                                                 |        | (214     | )      |          |        | (1,237   | )      |          |        | (1,335   | )       |          |         | (565  | )       |   |         | (241   | )       |   |         | (823   | )      
|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       
|                               |                               | Total nonoperating income (expense)                                             |        |          | (96    | )        |        |          | (1,123 | )        |        |          | (1,248  | )        |         |       | (276    | ) |         |        | 1,045   |   |         |        | (368    | )
|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       
|                               |                               | Net loss                                                                        |        |          | (5,939 | )        |        |          | (5,611 | )        |        |          | (12,097 | )        |         |       | (12,324 | ) |         |        | (15,476 | ) |         |        | (23,055 | )
|                               |                               | Less mandatorily convertible redeemable
preferred stock dividends and accretion |        |          | (192   | )        |        |          | (414   | )        |        |          | (368    | )        |         |       | (680    | ) |         |        |         |   |         |        |         |  
|                               |                               | Less deemed dividend related to beneficial
conversion feature                   |        |          |       |          |        |          |       |          |        |          |        |          |         |       |        |   |         |        |         |   |         |        |         |  
|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       
|                               |                               | Net loss attributable to common stockholders                                    |        | $        | (6,131 | )        |        | $        | (6,025 | )        |        | $        | (12,465 | )        |         | $     | (13,004 | ) |         | $      | (15,476 | ) |         | $      | (23,055 | )
|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       
|EBITDA                         |                               | $                                                                               | (5,042 | )        |        | $        | (3,625 | )        |        | $        | (9,764 | )        |         | $        | (10,425 | )     |         | $ | (14,433 | )      |         | $ | (18,283 | )     
|                               |                               |                                                                                 |        |          |        |          |        |          |        |          |        |          |         |          |         |       |         |   |         |        |         |   |         |       

[Additional columns below]

[Continued from above table, first column(s) repeated]

|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |        |         |  
|------------------------------ | ----------------------------- | ------------------------------------------------------------------------------- | ------- | -------- | ------- | -------- | ------- | -------- | ------- | -------- | ------- | -------- | ------- | -------- | -------- | ------ | -------- | - | ------ | ------ | ------- | - | ------ | ------ | ------- | -
|                               |                               |                                                                                 |         | 3 Months |         | 3 Months |         | 3 Months |         | 3 Months |         | 3 Months |         | 3 Months
|                               |                               |                                                                                 |         | 09.30.00 |         | 12.31.00 |         | 03.31.01 |         | 06.30.01 |         | 09.30.01 |         | 12.31.01
|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |         
|Revenues                       |                               | $                                                                               | 54,415  |          |         | $        | 69,120  |          |         | $        | 75,044  |          |         | $        | 73,142   |        |          | $ | 68,569 |        |         | $ | 59,142 |       
|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       
|Operating expenses:            |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       
|                               | Network operations            |                                                                                 |         | 33,032   |         |          |         | 39,078   |         |          |         | 43,302   |         |          |          | 41,718 |          |   |        | 38,279 |         |   |        | 31,865 |        
|                               | Sales and marketing           |                                                                                 |         | 11,742   |         |          |         | 15,822   |         |          |         | 12,761   |         |          |          | 8,873  |          |   |        | 3,885  |         |   |        | 5,724  |        
|                               | Research and development      |                                                                                 |         | 2,132    |         |          |         | 3,055    |         |          |         | 2,367    |         |          |          | 2,555  |          |   |        | 2,250  |         |   |        | 1,763  |        
|                               | General and administrative    |                                                                                 |         | 24,429   |         |          |         | 35,562   |         |          |         | 30,203   |         |          |          | 62,197 |          |   |        | 31,089 |         |   |        | 23,683 |        
|                               | Impairment of assets          |                                                                                 |         |         |         |          |         |         |         |          |         |         |         |          |          | 59,194 |          |   |        |       |         |   |        | 53     |        
|                               | Depreciation and amortization |                                                                                 |         | 5,308    |         |          |         | 5,366    |         |          |         | 6,041    |         |          |          | 6,483  |          |   |        | 5,279  |         |   |        | 5,474  |        
|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       
|                               |                               | Total operating expenses                                                        |         |          | 76,643  |          |         |          | 98,883  |          |         |          | 94,674  |          |          |        | 181,020  |   |        |        | 80,782  |   |        |        | 68,562  |  
|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       
|                               |                               | Operating loss                                                                  |         |          | (22,228 | )        |         |          | (29,763 | )        |         |          | (19,630 | )        |          |        | (107,878 | ) |        |        | (12,213 | ) |        |        | (9,420  | )
|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       
|Nonoperating income (expense): |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       
|                               | Interest
and other income     |                                                                                 |         | 736      |         |          |         | 2,998    |         |          |         | 2,918    |         |          |          | 1,352  |          |   |        | 1,531  |         |   |        | 1,061  |        
|                               | Interest
and other expense    |                                                                                 |         | (1,617   | )       |          |         | 368      |         |          |         | (868     | )       |          |          | (1,217 | )        |   |        | (1,173 | )       |   |        | (531   | )      
|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       
|                               |                               | Total nonoperating income (expense)                                             |         |          | (881    | )        |         |          | 3,366   |          |         |          | 2,050   |          |          |        | 135      |   |        |        | 358     |   |        |        | 530     |  
|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       
|                               |                               | Net loss                                                                        |         |          | (23,109 | )        |         |          | (26,397 | )        |         |          | (17,580 | )        |          |        | (107,743 | ) |        |        | (11,855 | ) |        |        | (8,890  | )
|                               |                               | Less mandatorily convertible redeemable
preferred stock dividends and accretion |         |          | (1,257  | )        |         |          | (2,387  | )        |         |          | (2,544  | )        |          |        | (3,047   | ) |        |        | (5,278  | ) |        |        | (4,190  | )
|                               |                               | Less deemed dividend related to beneficial
conversion feature                   |         |          | (7,358  | )        |         |          | (12,669 | )        |         |          |        |          |          |        |         |   |        |        | (8,885  | ) |        |        | (471    | )
|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       
|                               |                               | Net loss attributable to common stockholders                                    |         | $        | (31,724 | )        |         | $        | (41,453 | )        |         | $        | (20,124 | )        |          | $      | (110,790 | ) |        | $      | (26,018 | ) |        | $      | (13,551 | )
|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       
|EBITDA                         |                               | $                                                                               | (16,920 | )        |         | $        | (24,397 | )        |         | $        | (13,589 | )        |         | $        | (101,395 | )      |          | $ | (6,934 | )      |         | $ | (3,946 | )     
|                               |                               |                                                                                 |         |          |         |          |         |          |         |          |         |          |         |          |          |        |          |   |        |        |         |   |        |       

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##### Table of Contents



Z-Tel Technologies, Inc. and Subsidiaries
Consolidated Quarterly Statements of Operations
(As a percentage of quarterly revenue)
(Unaudited)



|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |    |     |  
|------------------------------ | ----------------------------- | ------------------------------------------------------------------------------- | ---- | -------- | ---- | -------- | ---- | -------- | ---- | -------- | ----- | -------- | ----- | -------- | ---- | --- | ---- | - | ---- | -- | ---- | - | --- | -- | --- | -
|                               |                               |                                                                                 |      | 3 Months |      | 3 Months |      | 3 Months |      | 3 Months |       | 3 Months |       | 3 Months
|                               |                               |                                                                                 |      | 03.31.99 |      | 06.30.99 |      | 09.30.99 |      | 12.31.99 |       | 03.31.00 |       | 06.30.00
|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |         
|Revenues                       |                               |                                                                                 | 100  | %        |      |          | 100  | %        |      |          | 100   | %        |       |          | 100  | %   |      |   | 100  | %  |      |   | 100 | % 
|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   
|Operating expenses:            |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   
|                               | Network operations            |                                                                                 |      | 122      | %    |          |      | 129      | %    |          |       | 274      | %     |          |      | 60  | %    |   |      | 70 | %    |   |     | 63 | %  
|                               | Sales and marketing           |                                                                                 |      | 178      | %    |          |      | 88       | %    |          |       | 283      | %     |          |      | 111 | %    |   |      | 49 | %    |   |     | 26 | %  
|                               | Research and development      |                                                                                 |      | 168      | %    |          |      | 46       | %    |          |       | 155      | %     |          |      | 21  | %    |   |      | 9  | %    |   |     | 4  | %  
|                               | General and administrative    |                                                                                 |      | 391      | %    |          |      | 314      | %    |          |       | 699      | %     |          |      | 142 | %    |   |      | 75 | %    |   |     | 52 | %  
|                               | Impairment of assets          |                                                                                 |      | 0        | %    |          |      | 0        | %    |          |       | 0        | %     |          |      | 0   | %    |   |      | 0  | %    |   |     | 0  | %  
|                               | Depreciation and amortization |                                                                                 |      | 121      | %    |          |      | 113      | %    |          |       | 146      | %     |          |      | 37  | %    |   |      | 15 | %    |   |     | 11 | %  
|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   
|                               |                               | Total operating expenses                                                        |      |          | 980  | %        |      |          | 690  | %        |       |          | 1557  | %        |      |     | 371  | % |      |    | 218  | % |     |    | 156 | %
|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   
|                               |                               | Operating loss                                                                  |      |          | -880 | %        |      |          | -590 | %        |       |          | -1457 | %        |      |     | -271 | % |      |    | -118 | % |     |    | -56 | %
|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   
|Nonoperating income (expense): |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   
|                               | Interest and other income     |                                                                                 |      | 18       | %    |          |      | 15       | %    |          |       | 11       | %     |          |      | 7   | %    |   |      | 9  | %    |   |     | 1  | %  
|                               | Interest and other expense    |                                                                                 |      | -32      | %    |          |      | -163     | %    |          |       | -179     | %     |          |      | -13 | %    |   |      | -2 | %    |   |     | -2 | %  
|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   
|                               |                               | Total nonoperating income (expense)                                             |      |          | -14  | %        |      |          | -148 | %        |       |          | -168  | %        |      |     | -6   | % |      |    | 7    | % |     |    | -1  | %
|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   
|                               |                               | Net loss                                                                        |      |          | -894 | %        |      |          | -738 | %        |       |          | -1625 | %        |      |     | -277 | % |      |    | -111 | % |     |    | -57 | %
|                               |                               | Less mandatorily convertible redeemable
preferred stock dividends and accretion |      |          | -29  | %        |      |          | -54  | %        |       |          | -49   | %        |      |     | -15  | % |      |    | 0    | % |     |    | 0   | %
|                               |                               | Less deemed dividend related to beneficial
conversion feature                   |      |          | 0    | %        |      |          | 0    | %        |       |          | 0     | %        |      |     | 0    | % |      |    | 0    | % |     |    | 0   | %
|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   
|                               |                               | Net loss attributable to common stockholders                                    |      |          | -923 | %        |      |          | -792 | %        |       |          | -1674 | %        |      |     | -292 | % |      |    | -111 | % |     |    | -57 | %
|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   
|EBITDA                         |                               |                                                                                 | -759 | %        |      |          | -476 | %        |      |          | -1311 | %        |       |          | -235 | %   |      |   | -103 | %  |      |   | -46 | % 
|                               |                               |                                                                                 |      |          |      |          |      |          |      |          |       |          |       |          |      |     |      |   |      |    |      |   |     |   

[Additional columns below]

[Continued from above table, first column(s) repeated]

|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |    |     |  
|------------------------------ | ----------------------------- | ------------------------------------------------------------------------------- | --- | -------- | --- | -------- | --- | -------- | --- | -------- | --- | -------- | --- | -------- | ---- | -- | ---- | - | --- | -- | --- | - | --- | -- | --- | -
|                               |                               |                                                                                 |     | 3 Months |     | 3 Months |     | 3 Months |     | 3 Months |     | 3 Months |     | 3 Months
|                               |                               |                                                                                 |     | 09.30.00 |     | 12.31.00 |     | 03.31.01 |     | 06.30.01 |     | 09.30.01 |     | 12.31.01
|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |         
|Revenues                       |                               |                                                                                 | 100 | %        |     |          | 100 | %        |     |          | 100 | %        |     |          | 100  | %  |      |   | 100 | %  |     |   | 100 | % 
|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   
|Operating expenses:            |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   
|                               | Network operations            |                                                                                 |     | 61       | %   |          |     | 57       | %   |          |     | 58       | %   |          |      | 57 | %    |   |     | 56 | %   |   |     | 54 | %  
|                               | Sales and marketing           |                                                                                 |     | 21       | %   |          |     | 23       | %   |          |     | 17       | %   |          |      | 12 | %    |   |     | 6  | %   |   |     | 10 | %  
|                               | Research and development      |                                                                                 |     | 4        | %   |          |     | 4        | %   |          |     | 3        | %   |          |      | 3  | %    |   |     | 3  | %   |   |     | 3  | %  
|                               | General and administrative    |                                                                                 |     | 45       | %   |          |     | 51       | %   |          |     | 40       | %   |          |      | 85 | %    |   |     | 45 | %   |   |     | 40 | %  
|                               | Impairment of assets          |                                                                                 |     | 0        | %   |          |     | 0        | %   |          |     | 0        | %   |          |      | 81 | %    |   |     | 0  | %   |   |     | 0  | %  
|                               | Depreciation and amortization |                                                                                 |     | 10       | %   |          |     | 8        | %   |          |     | 8        | %   |          |      | 9  | %    |   |     | 8  | %   |   |     | 9  | %  
|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   
|                               |                               | Total operating expenses                                                        |     |          | 141 | %        |     |          | 143 | %        |     |          | 126 | %        |      |    | 247  | % |     |    | 118 | % |     |    | 116 | %
|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   
|                               |                               | Operating loss                                                                  |     |          | -41 | %        |     |          | -43 | %        |     |          | -26 | %        |      |    | -147 | % |     |    | -18 | % |     |    | -16 | %
|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   
|Nonoperating income (expense): |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   
|                               | Interest and other income     |                                                                                 |     | 1        | %   |          |     | 4        | %   |          |     | 3        | %   |          |      | 2  | %    |   |     | 2  | %   |   |     | 2  | %  
|                               | Interest and other expense    |                                                                                 |     | -2       | %   |          |     | 0        | %   |          |     | -1       | %   |          |      | -2 | %    |   |     | -1 | %   |   |     | -1 | %  
|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   
|                               |                               | Total nonoperating income (expense)                                             |     |          | -1  | %        |     |          | 4   | %        |     |          | 2   | %        |      |    | 0    | % |     |    | 1   | % |     |    | 1   | %
|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   
|                               |                               | Net loss                                                                        |     |          | -42 | %        |     |          | -39 | %        |     |          | -24 | %        |      |    | -147 | % |     |    | -17 | % |     |    | -15 | %
|                               |                               | Less mandatorily convertible redeemable
preferred stock dividends and accretion |     |          | -2  | %        |     |          | -3  | %        |     |          | -3  | %        |      |    | -4   | % |     |    | -8  | % |     |    | -7  | %
|                               |                               | Less deemed dividend related to beneficial
conversion feature                   |     |          | -14 | %        |     |          | -18 | %        |     |          | 0   | %        |      |    | 0    | % |     |    | -13 | % |     |    | -1  | %
|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   
|                               |                               | Net loss attributable to common stockholders                                    |     |          | -58 | %        |     |          | -60 | %        |     |          | -27 | %        |      |    | -151 | % |     |    | -38 | % |     |    | -23 | %
|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   
|EBITDA                         |                               |                                                                                 | -31 | %        |     |          | -35 | %        |     |          | -18 | %        |     |          | -139 | %  |      |   | -10 | %  |     |   | -7  | % 
|                               |                               |                                                                                 |     |          |     |          |     |          |     |          |     |          |     |          |      |    |      |   |     |    |     |   |     |   

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##### Table of Contents



LIQUIDITY AND CAPITAL RESOURCES

The competitive local telecommunications service business is traditionally
considered to be a capital intensive business owing to the significant
investments required in fiber optic communication networks and the colocation
of switching and transmission equipment in incumbent local exchange carriers
central offices. Although we will continue our capital expenditures we do not
expect that the growth of our business will require the levels of capital investment
in fiber optics and switches that existed in historical telecommunications
facilities-based models. Instead, we will devote significant amounts of our
capital resources to continued operations, software development and marketing
efforts that we have designed to achieve rapid penetration of our target
markets.

We have incurred accumulated losses since our inception as a result of
developing our business, research and development, building and maintaining
network infrastructure and technology, sales and promotion of our services, and
administrative expenditures. As of December 31, 2001, we had an accumulated
deficit of $283.2 million, a net tax operating loss carryforward of $260.0
million, and $18.9 million in cash and cash equivalents. We have funded these
expenditures primarily through operating revenues, private securities
offerings, a sale-leaseback credit facility, sales of accounts receivable and
an initial public offering of 6.9 million shares of common stock (including the
underwriters over-allotment option) that raised net proceeds of $109.1
million. We intend to continue building our organization in anticipation of
future growth and believe that our operating expenditures will also continue to
increase.

In February 2000, we paid $14.4 million to extinguish the outstanding CMB
Capital, LLC capital lease obligation and purchase the related assets. This was
the repayment of transactions involving the sale-leaseback of various furniture
and equipment payable over four years from the date of the transactions.

In April 2000, we completed the acquisition of Touch 1 for approximately $9.0
million in cash and 1.1 million shares of our common stock. The Touch 1
acquisition was accounted for using the purchase method of accounting. The
acquisition of Touch 1 resulted in a total of $67.8 million of intangible
assets, consisting of $9.2 million for customer lists and $58.6 million for
goodwill, being amortized over 5 and 20 years, respectively. We recorded a
$59.2 million impairment charge during 2001 as a result of the
sale and closure of the
telemarketing centers acquired from Touch 1. As of December 31, 2001 there are
$5.9 million of intangible assets remaining related to customer lists.

In July 2000, we filed a Certificate of Designation authorizing the issuance of
5.0 million shares of $.01 par value Series D Convertible Preferred Stock
(Series D Preferred). We received aggregate proceeds of $56.3 million in
connection with the sale of 4,688,247 shares of Series D Preferred at a price
of $12.00. The deal costs associated with the transaction were $0.4 million.
The Series D Preferred had an original conversion price of $12.00, which price
is subject to adjustment for such items as; (i) a dividend or distribution to
common shareholders (whether such dividend or distribution is in stock,
securities, or other property), (ii) a stock split, (iii) a stock combination,
(iv) a reclassification of common stock, (v) the issuance of stock or
securities convertible into or exercisable for our common stock at a price that
is less than the conversion price, and (vi) other events the would cause
dilution in the ownership of the holders of the Series D Preferred stock. As a
result of these events the conversion price at December 31, 2001
is $8.79. The
Series D Preferred is convertible into common stock at the option of the holder
(i.e., initially convertible on a one-for-one basis); however, there are
certain circumstances that provide for a forced conversion of the stock by us.
Series D Preferred is mandatorily redeemable 8 years from the original issue
date, has an 8% cumulative dividend payable at times in cash and at times with
in- kind contributions of additional Series D Preferred and has certain
liquidation preferences and voting rights. Each purchaser of Series D Preferred
received a warrant to purchase a number of shares of our common stock equal to
one-half of the amount of Series D Preferred purchased by such investor. Each
warrants original exercise price was $13.80 per share subject to certain
adjustments that have lowered the exercise price to $10.52 per share, at
December 31, 2001.

In July 2000, we entered into an accounts receivable facility with RFC Capital
Corporation, a division of Textron, Inc. (RFC), providing for the sale of
certain of our accounts receivable to RFC. RFC has agreed to purchase up to
$25.0 million of our accounts receivable, with provisions for a commitment of
up to $50.0 million, subject to successful syndication of the receivables sales
program by RFC. We sold $1.4 million of receivables, for net proceeds of $0.8
million, for the year ended December 31, 2000. We recorded a loss of $0.6
million for the sale of these receivables during 2000. We did not have any
other transactions relating to this facility in 2000. See our
discussion of net cash used in operating activities for a discussion of the
current year activities related to the RFC agreement.

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##### Table of Contents



In July 2000, we also entered into an agreement with a service firm to provide
various content and new service offerings through the telephone. Under this
agreement we have invested $3.0 million in 2000. We terminated this contract
in 2001 and recorded a $3.0 million impairment charge in 2001. We have no
further obligations under this agreement.

In August 2000, we entered into an agreement with a service firm to outsource
customer provisioning through electronic bonding with incumbent local exchange
carriers. Under this agreement, we paid $6.3 million in 2001, and we have
committed to minimum cash payments subject to certain adjustments of $7.7,
and $9.0 million for the years ended December 31, 2002 and 2003,
respectively. The payments of these fees are subject to the successful
completion by the service firm of certain obligations in the future. This
contract provides for various termination arrangements with related severance
fees.

In November 2000, we filed a Certificate of Designation authorizing the
issuance of approximately 6.3 million shares of $.01 par value Series E
Convertible Preferred Stock (Series E Preferred). We received net proceeds of
approximately $50.0 million in connection with the sale of 4,166,667 shares of
Series E Preferred at a price of $12.00. The purchaser of Series E preferred
received a warrant to purchase a number of shares of our common stock equal to
one-half of the amount of Series E Preferred purchased by such investor.
Series E Preferred was originally convertible at a conversion price of $12.00,
which price is subject to adjustment, for such items as; (i) a dividend or
distribution to common shareholders (whether such dividend or distribution is
in stock, securities, or other property), (ii) a stock split, (iii) a stock
combination, (iv) a reclassification of common stock, (v) the issuance of stock
or securities convertible into or exercisable for our common stock at a price
that is less than the conversion price, and (vi) other events the would cause
dilution in the ownership of the holders of the Series E Preferred stock. As a
result of certain of these events the conversion price at December 31, 2001 is
$8.42. The Series E Preferred is convertible into common stock at the option
of the holder (i.e., initially convertible on a one-for-one basis); however,
there are certain circumstances that provide for a forced conversion of the
stock by us. Series E Preferred is mandatorily redeemable 8 years from the
original issue date has an 8% cumulative dividend payable in cash and has
certain liquidation preferences and voting rights. Each warrant is exercisable
at a price of $13.80 per share subject to certain adjustments that have lowered
the exercise price to $8.71 per share, at December 31, 2001.

In December 2000, we sold marketable securities for $3.5 million; this sale
resulted in a gain of $2.7 million. The proceeds were used to fund operations.

In January 2001, we accelerated the vesting of 50,000 stock options granted to
an executive as part of his severance agreement. This acceleration resulted in
the employee being fully vested in stock options with a strike price of $3.64
when the stock was trading at $4.50. We recorded approximately $0.1 million in
general and administrative expense as a result of this transaction.

In February 2001, we made a loan to an employee in the amount of 0.1 million.
The interest rate of this note is 9.5% and it is payable as a balloon payment
on February 23, 2003. This note is collateralized by any and all stock
options, rights to salary and wages, and all property personal, tangible, and
intangible of the employee.

In July 2001, we filed a Certificate of Designation authorizing the issuance of
175 shares of Series G junior convertible preferred stock (Series G
Preferred). On July 2 and August 3, 2001, we issued an aggregate of 175 shares
of Series G Preferred for aggregate proceeds of $17.5 million, initially
convertible into 11,739,970 shares of common stock, subject to adjustment upon
the occurrence of certain events that would cause dilution in the ownership of
the holders of the Series G Preferred, such as; (i) a dividend or distribution
to common shareholders (whether such dividend or distribution is in stock,
securities, or other property), (ii) a stock split, (iii) a stock combination,
(iv) a reclassification of common stock, and, (v) the issuance of stock or
securities convertible into or exercisable for our common stock at a price that
is less than the conversion price. As of December 31, 2001 the conversion
price was $1.49. In conjunction with the issuance of the Series G Preferred,
we issued warrants to purchase 3,000,000 shares of common stock at an exercise
price of $0.01 per share. The Series G Preferred was redeemable on December
31, 2001 unless shareholder approval was obtained. Once shareholder approval
was obtained the Series G Preferred became mandatorily redeemable 5 years from
September 18, 2001. The Series G Preferred have a 12% cumulative dividend, is
convertible
at the option of the holder and has certain liquidation rights; however, there
are certain circumstances that provide for a automatic conversion of the Series
G Preferred.

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In accordance with generally accepted accounting principles, we recorded a
deemed dividend of approximately $1.5 million, which results from the value
assigned to the warrants and a beneficial conversion feature associated with
the Series G Preferred transaction. These deemed dividends were originally
accreted over a life through December 31, 2001, the earliest redemption date.
Once shareholder approval was obtained, on October 30, 2001, the remaining
balance has been and will continue to be accreted over the remaining 5-year
redemption period.

As a result of certain anti-dilution clauses in the Series D Preferred
agreement, the issuance of Series G Preferred triggered an additional
beneficial conversion feature related to the Series D agreement. The deemed
dividend of approximately $7.9 million was accreted immediately in the third
quarter of 2001.

In June 2001, we as part of an executive severance agreement, paid an executive
approximately $0.3 million. This same executive received an interest free loan
of approximately $0.8 million, utilized to exercise stock options to purchase
187,000 shares of common stock. This note is collateralized by the shares of
common stock acquired with the note. We hold those shares as security.

In July 2001, we agreed to settle a lawsuit with AT&T in which we alleged that
AT&T had received originating and terminating access service from us and had
unlawfully withheld access charges for such services. As part of the
settlement, we entered into a switched access agreement setting forth terms and
conditions under which AT&T will purchase access services from us in the
future.

In August 2001, we cancelled approximately $0.7 million of notes receivable and
reacquired 61,875 shares of common stock at $1.14 per share from an employee.
At December 31, 2001 these shares are presented as treasury shares, at cost.

In September and October 2001, we loaned an
employee an aggregate of $0.1
million. The interest rate of this note is 6.5% and is payable as a balloon
payment on June 13, 2002. This note was for relocation of the
employee. There is no collateral pledge for this note.

Net cash used in operating activities improved by $75.1 million to $21.8
million for the year ended December 31, 2001, compared to $96.9 million used
for the same period in the prior year. The improvement resulted from improved
accounts receivable and accounts payable management, and from reductions in
payroll expenses, sales and marketing expenses and an overall decrease in
operating costs. These amounts were off-set by our intangible asset charge and
the accounts receivable write-down.

Included in our net cash used in operating activities for the year ended
December 31, 2001 was the sale of $156.3 million of receivables, for net
proceeds of $106.5 million. At December 31, 2001, a net receivable servicing
asset of $12.9 million is included in accounts receivable and $3.5 million of
advances on unbilled receivables are included in accounts payable and accrued
liabilities. The costs relating to the agreement of $1.1 million is included in
interest and other expense for the year ended December 31, 2001.

The RFC agreement allows us to sell up to $25 million of receivables, subject
to the selection criteria utilized by RFC for the selection of receivables they
agree to purchase. There are no minimum sales requirements under this agreement.
RFC purchases receivables from us at a discount of 32%, this rate is negotiated
and may change according to collection experience. Our collection percentages
during 2001 were 89%. Under the agreement we are responsible for the
continued servicing of the continued sold and any amount collected over the
32% discount rate is paid to us by RFC for providing the servicing less certain
fees.

The RFC agreement, although renewable for one-year terms, contractually
terminates in July 2002. We currently anticipate extending the term of the
agreement, under substantially similar terms; however, the extension cannot be assured.

Our net cash used in investing activities improved by $25.0 million to $15.6
million for the year ended December 31, 2001, compared to $40.6 million for the
same period in the prior year. This change is primarily a result of capital
expenditures being $15.4 million for the year ended December 31, 2001, compared
to $34.9 million in the same period
of the prior year. The remaining difference is the purchase of Touch 1 for $9.0
million and the purchase of $1.0 million of securities in 2000. During 2000,
our efforts were directed toward enhancing our network and billing
infrastructure.

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Our net cash provided by financing activities decreased by $72.8 million to
$9.7 million for the year ended December 31, 2001 compared to $82.5 million in
the prior year. This decrease is primarily a result of receiving only $17.5
million of mandatorily redeemable preferred stock in 2001 compared to $106.3
million in 2000. This change was off-set by payments on long-term debt and
capital lease obligations totaling $7.5 million for the year ended December 31,
2001. These payments related to the retirement of a $3.0 million balloon
facility and $4.5 million relating to the payment of other debt we assumed in
the Touch 1 acquisition. We expect to have a low amount of long-term debt
although if terms became available to obtain a more traditional loan we would
likely move from the existing accounts receivable agreement to a more
traditional loan, if such opportunity would arise with terms we deemed
appropriate. Our existing debt is primarily related party, with fixed
interest that is payable in monthly installments.

Our short-term liquidity relies heavily upon our accounts receivable
agreement, cash used or provided from operations, cash management strategies,
and if needed, our ability to reduce certain discretionary capital and
marketing expenses costs and the reduction of headcount to fulfill any short
term cash requirements. We have historically had negative cash flows and
although we expect to achieve positive EBITDA and cash-flows during 2002 we
also are aware of the risks, discussed throughout this document, of
not achieving
our goal.

Our ongoing capital requirements will depend on several factors, including
market acceptance of our services, the amount of resources we devote to
investments in our networks, facilities, build-out of additional enterprise
management centers, services development and brand promotions, the resources we
devote to sales and marketing of our services, and other factors. We believe
there is an opportunity to provide our back-office and the technology we have
developed to other companies seeking the capability of offering residential and
small business telecommunication services. As growth and opportunities arise,
we expect to make strategic investments in technology and our network
architecture and enter potential strategic alliances or partnerships with other
entities.

We will make investments in sales and marketing to build our overall Z brand,
build strategic partnerships, and develop new service offerings in an attempt
to attract new customers. We will focus on what we expect to be more attractive
distribution channels which are expected to
achieve cost effective acquisition costs per subscriber.

On January 22, 2002, the Securities and Exchange Commission issued FR-61,
Commission Statement about Managements Discussion and Analysis of Financial
Condition and Results of Operations.The release sets forth certain views of
the Commission regarding disclosure that should be considered by registrants.
Disclosure matters addressed by the release are liquidity and capital resources
including off-balance sheet arrangements, certain trading activities that
include non-exchange traded contracts accounted for at fair value, and effects
of transactions with related and certain other parties. The following
table sets
forth the information and format described in the release with regard to
disclosures about contractual obligations and commercial commitments. These
disclosures are also included in the notes to the financial statement and
cross-referenced in the tables below.

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The following table discloses aggregate information about our contractual
obligations and the periods in which payments are due:

|                                                  |  |       |         |        |  |           |        |           |  |         |        |  |  |   |        |       |  |   |         | 
|------------------------------------------------- |  | ----- | ------- | ------ |  | --------- | ------ | --------- |  | ------- | ------ |  |  | - | ------ | ----- |  | - | ------- | 
|                                                  |  |       |         |        |  | Less than |        |           |  |         |        |  |  |   |        | After
|Contractual Obligations                           |  | Total |         | 1 year |  | 1-3 years |        | 4-5 years |  | 5 years
|                                                  |  |       |         |        |  |           |        |           |  |        
|Long-term debt (1)                                |  | $     | 13,409  |        |  | $         | 4,880  |           |  | $       | 8,529  |  |  | $ |       |       |  | $ |        | 
|Operating leases                                  |  |       | 18,490  |        |  |           | 3,475  |           |  |         | 9,747  |  |  |   | 2,844  |       |  |   | 2,424   | 
|Capital leases                                    |  |       | 2,703   |        |  |           | 1,635  |           |  |         | 1,068  |  |  |   |        |       |  |   |         | 
|Mandatorily redeemable preferred stock redemption |  |       | 135,298 |        |  |           |        |           |  |         |        |  |  |   | 18,436 |       |  |   | 116,862 | 
|Unconditional purchase obligations                |  |       | 18,230  |        |  |           | 8,630  |           |  |         | 9,600  |  |  |   |        |       |  |   |         | 
|                                                  |  |       |         |        |  |           |        |           |  |         |        |  |  |   |        |       |  |   |         | 
|Total contractual cash obligations                |  | $     | 188,130 |        |  | $         | 18,620 |           |  | $       | 28,944 |  |  | $ | 21,280 |       |  | $ | 119,286 | 
|                                                  |  |       |         |        |  |           |        |           |  |         |        |  |  |   |        |       |  |   |         | 



|(1) |  | The Company has no related
party obligations other than those listed in footnote 10- Long-Term Debt, of our Consolidated Financial
Statements.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------

NEW ACCOUNTING PRONOUNCEMENTS

The new accounting pronouncements, in Footnote 1  Nature of Business of our
Consolidated Financial Statements are incorporated by reference.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

The forward-looking statements in this document are based on the belief of
our management, as well as assumptions made by and information currently
available to our management. Forward-looking statements also may be included in
other written and oral statements made or released by us. You can identify
forward-looking statements by the fact that they do not relate strictly to
historical or current facts. The words believe, anticipate, intend,
expect, estimate, project and similar expressions are intended to
identify forward-looking statements. Forward-looking statements describe our
expectations today of what we believe is most likely to occur or may be
reasonably achievable in the future, but they do not predict or assure any
future occurrence and may turn out to be wrong. Forward-looking statements are
subject to both known and unknown risks and uncertainties and can be affected
by inaccurate assumptions we might make. Consequently, no forward-looking
statement can be guaranteed. Actual future results may vary materially. We do
not undertake any obligation to publicly update any forward-looking statements
to reflect new information or future events or occurrences. These statements
reflect our current views with respect to future events and are subject to
risks and uncertainties about us, including, among other things:



| |  |  | our ability to market our services successfully to new subscribers;                                                                                        
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | our ability to retain a high
percentage of our customers;                                                                                                  
|
| |  |  | the possibility of unforeseen capital expenditures and other
upfront investments required to deploy new technologies or to effect
new business initiatives;
|
| |  |  | our ability to access markets and finance network developments and operations;                                                                             
|
| |  |  | our enhancement and expansion, including consumer acceptance of new price plans and bundled offerings;                                                     
|
| |  |  | additions or departures of key personnel;                                                                                                                  
|
| |  |  | competition, including the introduction of new products or services by our competitors;                                                                    

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| |  |  | existing and future laws or regulations affecting our business and our ability to comply with these laws or regulations;
| | - |  | ------------------------------------------------------------------------------------------------------------------------
|
| |  |  | our reliance on the Regional Bell operating companys systems and provisioning processes;                               
|
| |  |  | technological innovations;                                                                                              
|
| |  |  | general economic and business conditions, both nationally and in the regions in which we operate; and                   
|
| |  |  | other factors described in this document, including those described in more detail below.                               

We caution you not to place undue reliance on these forward-looking
statements, which speak only as of the date of this document.

RISKS RELATED TO OUR FINANCIAL CONDITION AND OUR BUSINESS

Limited Operating History.We were formed in January 1998 and began
offering telecommunications services to the public in September 1998. Moreover,
we launched our principal service Z-LineHOME in June 1999. We have had fewer
than four years of actual marketing, sales and operational results. Our limited
operating history and results make it very difficult to evaluate or predict our
ability to, among other things, retain customers, generate and sustain a
revenue base sufficient to cover our operating expenses, and to achieve
profitability. As a result, we believe that our historical financial
information is of little or no value in projecting our future results, making
it even more difficult to evaluate our business and prospects.

Uncertain Demand.We began marketing our products and services in
September 1998. In June 1999, we focused our product offering on sales of our
Z-LineHOME service. Our Z-LineBUSINESS service and our planned wholesale
initiative are in their infancy. Our products and services represent an
emerging sector of the telecommunications industry, and the demand for our
services and our ability to retain customers over time are highly uncertain.
User acceptance of our products and services could be limited by:



| |  |  | the willingness of customers to accept Z-Tel as an alternative
provider of local and long distance telephone services and of other
enhanced, integrated services;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the presence and attractiveness of other enhanced telecommunications
service offerings in our target markets;                                                    
|
| |  |  | the perception of complexity in using our services;                                                                                                              
|
| |  |  | the reliability of our technology and network infrastructure;                                                                                                    
|
| |  |  | the quality of our billing,
provisioning and customer service; and                                                                                               
|
| |  |  | the prices of our services.                                                                                                                                      

We have determined that substantial marketing effort, time and expense are
required to stimulate initial demand for our retail products and services. In
addition, we have incurred and will continue to incur substantial operating
expenses, have made, and will continue to make, significant capital investments
and have entered or plan to enter into real property leases, equipment supply
contracts and service arrangements, in each case based upon our expectations as
to the market acceptance of our products and services. We cannot be certain
that substantial markets will develop for our products and services, or, if
such markets develop, that we will be able to attract and maintain a sufficient
revenue-generating customer base to cover our operating expenses. Lack of
acceptance of our services in our target markets would materially and adversely
affect the commercial viability of our business, and as a consequence, the
value of your investment.

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In addition, to maintain our competitive posture, we must be in a position
to reduce the prices for our services in order to meet reductions in local and
long distance rates, if any, offered by others. We cannot be sure that we will
be able to match the reductions made by our competitors and, if we do, such
reductions could have an adverse effect on our business, operating results and
financial condition.

Expectation of Future Losses.Our product and service offerings are at an
early stage, and we cannot be sure that sales of our products or services will
generate revenues sufficient to cover our operating expenses. Therefore our
operations may not become profitable within the time frame we expect or at all.
Starting up our company and developing our communications technology required
substantial capital and other expenditures and further development of our
business will require significant additional expenditures.

Availability and Favorable Pricing of Unbundled Network Components.Our
business strategy depends on a continued availability of unbundled network
components and on existing and additional states maintaining and adopting
favorable pricing rules for unbundled network components. The public utilities
commissions of certain states have adopted pricing rules for unbundled network
components. As a result of these regulatory initiatives, the Bell operating
companies operating in those states are required to offer to competitive local
exchange carriers such as us, at forward-looking, long-run incremental
cost-based prices, the facilities and equipment and the features, functions and
capabilities of their local exchange network on an unbundled basis. We have
commenced operations in 38 states using unbundled network components. However,
given that the FCC order permitting unbundled network components is subject to
further appeal, we cannot be certain that unbundled network components will
continue to be available in their present form in those states or other states
or that such other states will ever adopt favorable unbundled network
components pricing. Further, regulatory changes may adversely affect unbundled
network components of our Z-LineHOME or Z-LineBUSINESS or adversely
affect our wholesale initiatives.
Our business model is based, in part, on availability and favorable pricing of
the unbundled network components, and any adverse changes in the unbundled
network elements platform regulatory or competitive environment could have a
material adverse effect on our business, financial condition and results of
operations.

Uncertainties Relating to Wholesale Initiative. Our wholesale initiative
is in its infancy. There is no assurance that it will contribute to gross
profit or otherwise be successful. We believe we are the first competitive
local exchange carrier to offer wholesale local exchange services. We
undoubtedly will encounter unforeseen delays, capital expenditures and upfront
costs, regulatory and legal issues (which may include legal challenges to our wholesale
strategy by incumbent local exchange carriers), technical difficulties and
other challenges. There can be no assurance that we will overcome these
challenges successfully or without expenditure of substantial resources.
Moreover, since we must pay the incumbent local exchange carrier fees relating
to local telephone usage by both our retail and wholesale customers, we will be
highly dependent upon our wholesale customers. Their failure to pay fees to us
may make it difficult or impossible for us to pay fees to the incumbent local
exchange carriers upon which we rely.

Rapid Expansion.We have rapidly expanded our operations since we were
formed. We expect to grow our business rapidly in terms of the number of
services we offer, the number of customers we serve and the regions we serve.
We cannot assure you that we will successfully manage our efforts to:



| |  |  | expand, train, manage and retain our employee base;                                                                            
| | - |  | -------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | expand and improve our customer service and support systems and
improve the performance of billing systems;                    
|
| |  |  | introduce and market new products and services and new pricing plans
in addition to Z-LineHOME and our other service offerings;
|
| |  |  | enhance and upgrade the features of our software;                                                                              
|
| |  |  | capitalize on new opportunities in the competitive marketplace; and                                                            
|
| |  |  | control our expenses.                                                                                                          

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The strains posed by these demands are magnified by the start-up nature of
our operations. If we cannot manage our growth effectively, our results of
operations could be adversely affected.

Difficulties in Expanding Network Infrastructure.We must continue to
develop, expand and adapt our network infrastructure as the number of our users
and the amount of information they wish to access and transfer increases and as
our customers demands change. We cannot be sure that we will be able to
develop, expand or adapt the network infrastructure to meet additional demand
or our customers changing requirements on a timely basis, at a commercially
reasonable cost, or at all. If we fail to expand our network infrastructure on
a timely basis or adapt it to either changing customer requirements or evolving
industry standards, these failures could cause our business to perform poorly.

Ability to Resell Long Distance Services.We offer long distance telephone
services as part of our service packages. We currently have agreements with
various long distance carriers to provide transmission and termination services
for all of our long distance traffic. Recently, several long distance carriers
have encountered financial difficulties, including at least one carrier
utilized by us. Financial difficulties encountered by any of our carriers
could cause disruption of service to our customers and could diminish the value
of any receivables or credits that may be due to us from such carriers. Our
agreements with long distance carriers generally provide for the resale of long
distance services on a per-minute basis and contain minimum volume commitments.
In cases in which we have agreed to minimum volume commitments and fail to meet
them, we will be obligated to pay underutilization charges. In some instances,
if we incur underutilization charges, our basic rate will increase, which could
further adversely affect our operating results. To date, we have not paid any
material underutilization charges.

Risk of Software Failures and Errors.The software that we use and the
software that we have developed internally and are continuing to develop may
contain undetected errors. Although we have extensively tested our software,
errors may be discovered in the software during the course of its use. Any
errors may result in partial or total failure of our network, loss or
diminution in service delivery performance, additional and unexpected expenses
to fund further product development or to add programming personnel to complete
or correct development, and loss of revenue because of the inability of
customers to use our products or services, which could adversely affect our
business condition.

Protection of Proprietary Technology.We currently rely on a combination
of copyright, trademark and trade secret laws and contractual confidentiality
provisions to protect the proprietary information that we have developed. Our
ability to protect our proprietary technology is limited, and we cannot assure
you that our means of protecting our proprietary rights will be adequate or
that our competitors will not independently develop similar technology. Also,
we cannot be certain that the intellectual property that incumbent local
exchange carriers or others claim to hold and that may be necessary for us to
provide our services will be available on commercially reasonable terms. If we
were found to be infringing upon the intellectual property rights of others, we
might be required to enter into royalty or licensing agreements, which may be
costly or not available on commercially reasonable terms. If successful, a
claim of infringement against us and our inability to license the infringed or
similar technology on terms acceptable to us could adversely affect our
business.

Dependence on Information Systems.Our billing, customer service and
management information systems are newly developed and we may face unexpected
system difficulties, which would adversely affect our service levels and,
consequently, our business.

Sophisticated information and processing systems are vital to our ability
to monitor costs, render monthly invoices for services, process customer orders
and achieve operating efficiencies. We rely on internal systems and third party
vendors, some of which have a limited operating history, to provide our
information and processing systems. If our systems fail to perform in a timely
and effective manner and at acceptable costs, or if we fail to adequately
identify all of our information and processing needs or if our related
processing or information systems fail, these failures could have a material
adverse effect on our business.

In addition, our right to use third party systems is dependent upon
license agreements. Some of these agreements are cancelable by the vendor, and
the cancellation or nonrenewal of these agreements could seriously impair our
ability to process orders or bill our customers. As we continue to provide
local telephone service, the need for sophisticated billing and information
systems will also increase significantly and we will have significant
additional requirements for data interface with incumbent local exchange
carriers and others. We cannot be certain that we will be able to meet these
additional requirements.

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Network Failure.The successful operation of our network will depend on a
continuous supply of electricity at multiple points. Although the system that
carries signals has been designed to operate under extreme weather conditions
(including heavy rain, wind and snow), like all other telecommunications
systems, our network could be adversely affected by such conditions. Our
network, however, is equipped with a back-up power supply and our existing
network operations center is equipped with both a battery backup and an on-site
emergency generator. If a power failure causes an interruption in our service,
the interruption could negatively impact our operations.

Our network also may be subject to physical damage, sabotage, tampering or
other breaches of security (by computer virus, break-ins or otherwise) that
could impair its functionality. In addition, our network is subject to unknown
capacity limitations that may cause interruptions in service or reduced
capacity for our customers. Any interruptions in service resulting from
physical damage or capacity limitations could cause our systems to fail.

Network Interconnection.As a competitive provider of local telephone
service, we must interconnect our network with the networks of incumbent local
exchange carriers. We may not be able to obtain the interconnection we require
at rates and on terms and conditions that permit us to offer services that are
both competitive and profitable. In the event that we experience difficulties
in obtaining high quality, reliable and reasonably priced services from other
carriers, the attractiveness of our services is likely to be significantly
impaired.

Dependence on Local Exchange Carriers.We rely on incumbent local exchange
carriers to supply key unbundled components of their network infrastructure to
us on a timely and accurate basis, and in the quantities and quality demanded
by us. We may from time to time experience delays or other problems in
receiving unbundled services or facilities which we request, and there can be
no assurance that we will able to obtain such unbundled elements on the scale
and within the time frames required by us. Any failure to obtain these
components, services or additional capacity on a timely and accurate basis
could adversely affect us.

Anticipated Capital Needs.If we expand more rapidly than currently
anticipated or if our working capital needs exceed our current expectations, we
may need to raise additional capital from debt or equity sources. If we cannot
obtain financing on acceptable terms or at all, we may be required to modify,
delay or abandon our current business plan, which is likely to materially and
adversely affect our business and, as a result, the value of our
common stock. We have an accounts
receivable facility with RFC Corporation
that provides for the sale of up to $25 million of our receivables to
RFC. This facility expires in July 2002.  Although we anticipate
extending the term of the facility, no extension is assured.
Furthermore, by letter dated February 14, 2002, Nasdaq informed us that
for a period of 30 days the price of our common stock closed below
the minimum $3.00 per share requirement for continued inclusion on
the Nasdaq National Market. We have 90 days from the date of that
letter to regain compliance or our shares will be delisted from the
National Market. Delisting may make it more difficult for us to obtain
additional financing through the sale of equity or otherwise.

Dependence on Third Party Vendors.We currently purchase the majority of
our telecommunications equipment as needed from third party vendors, including
Lucent Technologies, Inc., Sonus Networks, Inc., Dialogic Communications
Corporation, Hewlett-Packard Company, Compaq Computer Corporation, Sun
Microsystems, Inc. and EMC Corporation. In addition, we currently license our
software from third party vendors, including Oracle Corporation, INPRISE
Corporation, Mercator Software, Inc., Microsoft Corporation, Nuance
Communications, Inc., SpeechWorks International, Inc., Telution, Inc., AMS,
Inc., Netscape Communications, Inc. and Accenture. We typically do not enter
into any long-term agreements with our telecommunications equipment or software
suppliers. Any reduction or interruption in supply from our equipment suppliers
or failure to obtain suitable software licensing terms could have a disruptive
effect on our business and could adversely affect our results of operations.

Dependence on Management and Key Personnel.We depend on a limited number
of key personnel who would be difficult to replace. If we lose the services of
some of our key personnel, our business could suffer. We currently maintain a
$5,000,000 key man life insurance policy on the life of Mr. D. Gregory Smith,
our president, chief executive officer and chairman of the board. We also
depend on a limited number of key management, sales, marketing and product
development personnel to manage and operate our business. In particular, we
believe that our success depends to a significant degree upon our ability to
attract and retain highly skilled personnel, including our engineering and
technical staff. If we are unable to attract and retain our key employees, the
value of our common stock could suffer.

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RISKS RELATED TO OUR INDUSTRY

Government Regulation and Legal Uncertainties.We are subject to varying
degrees of federal, state, and local regulation. In states where we will
provide intrastate services, we generally will be subject to state
certification or registration and tariff-filing requirements. Delays in
obtaining the required state regulatory approvals may have a material adverse
effect on our business. Challenges to our tariffs by third parties could cause
us to incur substantial legal and administrative expenses.

We must also comply with various state and federal obligations that are
subject to change, such as the duty to contribute to universal service
subsidies, the impact of which we cannot assess on a going-forward basis as the
rates change periodically. While we do not believe that compliance with federal
and state reporting and regulatory requirements will be burdensome, our failure
to do so may result in fines or other penalties being imposed on us, including
loss of certification to provide services.

Decisions of the FCC and state regulatory commissions providing incumbent
local exchange carriers with increased flexibility in how they price their
services and with other regulatory relief, could have a material adverse effect
on our business and that of other competitive local exchange carriers. Future
regulatory provisions may be less favorable to competitive local exchange
carriers and more favorable to their competitors. If incumbent local exchange
carriers are allowed by regulators to lower their retail rates, engage in
substantial volume and term discount pricing practices for their end-user
customers, or charge competitive local exchange carriers higher fees for
interconnection to the incumbent local exchange carriers networks, our
business, operating results and financial condition could be materially
adversely affected. Incumbent local exchange carriers may also seek to delay
competitors through legal or regulatory challenges, or by recalcitrant
responses to requirements that they open their markets through interconnection
and unbundling of network elements. Our legal and administrative expenses may
be increased because of our having to actively participate in rate cases filed
by incumbent local exchange carriers, in which they seek to increase the rates
they can charge for the unbundled network element platform components. Our
profitability may be adversely affected if those carriers prevail in those
cases. Pending court cases, in which certain provisions of the
Telecommunications Act of 1996 will be conclusively interpreted, may result in
an increase in our cost of obtaining unbundled network elements.

We are also subject to federal and state laws and regulations prohibiting
slamming, which occurs when specific procedures are not followed when a
customer changes telecommunications services. Although we attempt to diligently
comply with all such laws and regulations and have procedures in place to
prevent slamming, if violations of such laws and regulations occur, we could
become subject to significant fines and penalties, legal fees and costs, and
our business reputation could be harmed.

Competition.The telecommunications and information services markets are
intensely competitive and rapidly evolving. We expect competition to increase
in the future. Many of our potential competitors have longer operating
histories, greater name recognition, larger customer bases and substantially
greater financial, personnel, marketing, engineering, technical and other
resources than us. We believe the principal competitive factors affecting our
business operations will be price, the desirability of our service offering,
quality and reliability of our services, innovation and customer service. Our
ability to compete effectively will depend upon our ability to maintain high
quality, market-driven services at prices generally equal to or below those
charged by our competitors. Competitor actions and responses to our actions
could, therefore, materially and adversely affect our business, financial
condition and results of operations.

We face competition from a variety of participants in the
telecommunications market. The largest competitor for local service in each
market in which we compete is the incumbent local exchange carrier serving that
market. Incumbent local exchange carriers have established networks,
long-standing relationships with their customers, strong political and
regulatory influence, and the benefit of state and federal regulations that,
until recently, favored incumbent local exchange carriers. In the local
exchange market, the incumbent local exchange carriers continue to hold
near-monopoly positions. The long distance telecommunications market in which
we compete has numerous entities competing for the same customers and a high
average churn rate as customers frequently change long distance providers in
response to the offering of lower rates or promotional incentives.

Prices in the long distance market have declined significantly in recent
years and are expected to continue to decline. We will face competition from
large interexchange carriers. Other competitors are likely to include incumbent
local exchange carriers providing out-of-region (and, with the removal of
regulatory barriers, in-region)
long distance services, other incumbent local exchange carriers, other
competitive local exchange carriers, cable television companies, electric
utilities, wireless telephone system operators, microwave and satellite
carriers and private networks owned by large end users.

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The Telecommunications Act of 1996 facilitates such entry by requiring
incumbent local exchange carriers to allow competing providers to acquire local
services at wholesale prices for resale and to purchase unbundled network
elements at cost-based prices. A continuing trend toward combinations and
strategic alliances in the telecommunications industry, including potential
consolidation among incumbent local exchange carriers or competitive local
exchange carriers, or transactions between telephone companies and cable
companies outside of the telephone companys service area, or between
interexchange carriers and competitive local exchange carriers, could give rise
to significant new competitors.

The enhanced and information services markets are also highly competitive
and we expect that competition will continue to intensify. Our competitors in
these markets will include information service providers, telecommunications
companies, on-line service providers and Internet service providers.

Unauthorized Transactions; Theft of Services.We may be the victim of
fraud or theft of service. From time to time, callers have obtained our
services without rendering payment by unlawfully using our access numbers and
personal identification numbers. We attempt to manage these theft and fraud
risks through our internal controls and our monitoring and blocking systems. If
these efforts are not successful, the theft of our services may cause our
revenue to decline significantly. To date, we have not encountered material
fraud or theft of our service.




Item 7a.Quantitative and Qualitative Disclosures about Market Risk

We do not enter into financial instruments for trading or speculative purposes
and do not currently utilize derivative financial instruments. Our operations
are conducted primarily in the United States and as such are not subject to
material foreign currency exchange rate risk.

The fair value of our investment portfolio or related income would not be
significantly impacted by either a 100 basis point increase or decrease in
interest rates due mainly to the short-term nature of the major portion of our
investment portfolio.

We have no material future earnings or cash flow exposures from changes in
interest rates on our long-term debt obligations, as substantially all of our
long-term debt obligations are fixed rate obligations.

45



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Item 8.Financial Statements and Supplementary Data

|                                                   |                                                                                               |  |      |     | 
|-------------------------------------------------- | --------------------------------------------------------------------------------------------- |  | ---- | --- | 
|                                                   |                                                                                               |  | Page
|                                                   |                                                                                               |  |     
|Report of Independent Certified Public Accountants |                                                                                               |  | F-2  |    
|Consolidated Financial Statements:                 |                                                                                               |  |      |    
|                                                   | Consolidated Balance Sheets                                                                   |  |      | F-3 | 
|                                                   | Consolidated Statements of Operations                                                         |  |      | F-4 | 
|                                                   | Consolidated Statements of Changes in Stockholders Equity (Deficit)
and Comprehensive Income |  |      | F-5 | 
|                                                   | Consolidated Statements of Cash Flows                                                         |  |      | F-6 | 
|Notes to Consolidated Financial Statements         |                                                                                               |  | F-9  |    

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REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

To the Board of Directors and Shareholders of
Z-Tel Technologies, Inc. and Subsidiaries

In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of changes in stockholders equity
(deficit) and comprehensive income and of cash flows present fairly, in all
material respects, the financial position of Z-Tel Technologies, Inc. and its
subsidiaries at December 31, 2001 and 2000, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2001 in conformity with accounting principles generally accepted in the
United States of America. These financial statements are the responsibility of
the Companys management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally accepted in the
United States of America, which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.

/s/PricewaterhouseCoopers LLP

Tampa, Florida
February 22, 2002, except Note 20,
as to which the date is March 20, 2002

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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)

|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |          |         |         | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------ | -------------------------------------------------------------------------------------------------------- | -------- | ------------ | ------- | ------ | -------- | ------- | ------- | 
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          | December 31,
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |             
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          | 2001         |         | 2000  
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |             
|Assets                                                                                                                                                                                                  |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|Current assets:                                                                                                                                                                                         |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|                                                                                                                                                                                                        | Cash and cash equivalents                                                                                                                                 |                                      | $                                                                                                        | 18,892   |              |         | $      | 46,650   |        
|                                                                                                                                                                                                        | Accounts receivable, net of allowance for doubtful
accounts of approximately $12,544 and $9,026                                                           |                                      |                                                                                                          | 27,042   |              |         |        | 65,432   |        
|                                                                                                                                                                                                        | Prepaid expenses and other current assets                                                                                                                 |                                      |                                                                                                          | 3,961    |              |         |        | 7,159    |        
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|                                                                                                                                                                                                        |                                                                                                                                                           | Total current assets                 |                                                                                                          |          | 49,895       |         |        |          | 119,241 |        
|Property and equipment, net                                                                                                                                                                             |                                                                                                                                                           |                                      | 56,231                                                                                                   |          |              |         | 59,200 |         
|Intangible assets, net                                                                                                                                                                                  |                                                                                                                                                           |                                      | 5,945                                                                                                    |          |              |         | 64,267 |         
|Other assets                                                                                                                                                                                            |                                                                                                                                                           |                                      | 4,666                                                                                                    |          |              |         | 3,753  |         
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      | Total assets                                                                                             |          | $            | 116,737 |        |          | $       | 246,461 | 
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|Liabilities, Mandatorily Redeemable Convertible Preferred
Stock and Stockholders Equity (Deficit)                                                                                                      |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|Current liabilities:                                                                                                                                                                                    |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|                                                                                                                                                                                                        | Accounts payable and accrued liabilities                                                                                                                  |                                      | $                                                                                                        | 49,622   |              |         | $      | 44,693   |        
|                                                                                                                                                                                                        | Deferred revenue                                                                                                                                          |                                      |                                                                                                          | 5,951    |              |         |        | 7,666    |        
|                                                                                                                                                                                                        | Current portion of long-term debt
and capital lease obligations                                                                                           |                                      |                                                                                                          | 6,305    |              |         |        | 7,637    |        
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|                                                                                                                                                                                                        |                                                                                                                                                           | Total current liabilities            |                                                                                                          |          | 61,878       |         |        |          | 59,996  |        
|Long-term debt and capital lease obligations                                                                                                                                                            |                                                                                                                                                           |                                      | 9,461                                                                                                    |          |              |         | 12,780 |         
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      | Total liabilities                                                                                        |          |              | 71,339  |        |          |         | 72,776  | 
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|Mandatorily redeemable convertible preferred stock, $.01 par value;
50,000,000 shares authorized; 8,855,089 and 8,854,914 issued
and outstanding (aggregate liquidation value of $135,298 and $108,808) |                                                                                                                                                           |                                      | 112,570                                                                                                  |          |              |         | 84,585 |         
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|Commitments and contingencies (Notes 14 and 19)                                                                                                                                                         |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|Stockholders equity:                                                                                                                                                                                   |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|                                                                                                                                                                                                        | Common stock, $.01 par value; 150,000,000
shares authorized; 34,341,855 and 34,033,910 shares issued;
34,000,305 and 33,754,235 outstanding, respectively |                                      |                                                                                                          | 343      |              |         |        | 340      |        
|                                                                                                                                                                                                        | Notes receivable from stockholders                                                                                                                        |                                      |                                                                                                          | (1,589   | )            |         |        | (839     | )      
|                                                                                                                                                                                                        | Unearned stock compensation                                                                                                                               |                                      |                                                                                                          | (122     | )            |         |        | (255     | )      
|                                                                                                                                                                                                        | Additional paid-in capital                                                                                                                                |                                      |                                                                                                          | 217,782  |              |         |        | 227,304  |        
|                                                                                                                                                                                                        | Accumulated deficit                                                                                                                                       |                                      |                                                                                                          | (283,198 | )            |         |        | (137,130 | )      
|                                                                                                                                                                                                        | Accumulated other comprehensive income                                                                                                                    |                                      |                                                                                                          |         |              |         |        | (2       | )      
|                                                                                                                                                                                                        | Treasury stock, 341,550 and 279,675 shares at cost                                                                                                        |                                      |                                                                                                          | (388     | )            |         |        | (318     | )      
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|                                                                                                                                                                                                        |                                                                                                                                                           | Total stockholders equity (deficit) |                                                                                                          |          | (67,172      | )       |        |          | 89,100  |        
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      | Total liabilities, mandatorily redeemable
convertible preferred stock and
stockholders equity (deficit) |          | $            | 116,737 |        |          | $       | 246,461 | 
|                                                                                                                                                                                                        |                                                                                                                                                           |                                      |                                                                                                          |          |              |         |        |         

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

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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share and per share data)

|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |        |         |  
|------------------------------------------ | ----------------------------- | ------------------------------------------------------------------------------- | ---------- | ------------ | -------- | ---- | ---------- | ------- | -------- | - | ---------- | ------ | ------- | -
|                                           |                               |                                                                                 |            | Year Ended  
|                                           |                               |                                                                                 |            | December 31,
|                                           |                               |                                                                                 |            |             
|                                           |                               |                                                                                 |            | 2001         |          | 2000 |            | 1999   
|                                           |                               |                                                                                 |            |              |          |      |            |        
|Revenues                                   |                               | $                                                                               | 275,897    |              |          | $    | 177,668    |         |          | $ | 6,615      |       
|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|Operating expenses:                        |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|                                           | Network operations            |                                                                                 |            | 155,164      |          |      |            | 107,077 |          |   |            | 6,518  |        
|                                           | Sales and marketing           |                                                                                 |            | 31,243       |          |      |            | 45,018  |          |   |            | 8,898  |        
|                                           | Research and development      |                                                                                 |            | 8,935        |          |      |            | 8,276   |          |   |            | 3,562  |        
|                                           | General and administrative    |                                                                                 |            | 147,172      |          |      |            | 91,330  |          |   |            | 16,493 |        
|                                           | Impairment of assets          |                                                                                 |            | 59,247       |          |      |            |        |          |   |            |       |        
|                                           | Depreciation and amortization |                                                                                 |            | 23,277       |          |      |            | 17,166  |          |   |            | 4,372  |        
|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|                                           |                               | Total operating expenses                                                        |            |              | 425,038  |      |            |         | 268,867  |   |            |        | 39,843  |  
|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|                                           |                               | Operating loss                                                                  |            |              | (149,141 | )    |            |         | (91,199  | ) |            |        | (33,228 | )
|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|Nonoperating income (expense):             |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|                                           | Interest and other income     |                                                                                 |            | 6,862        |          |      |            | 5,475   |          |   |            | 608    |        
|                                           | Interest and other expense    |                                                                                 |            | (3,789       | )        |      |            | (2,313  | )        |   |            | (3,351 | )      
|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|                                           |                               | Total nonoperating income (expense)                                             |            |              | 3,073    |      |            |         | 3,162    |   |            |        | (2,743  | )
|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|                                           |                               | Net loss                                                                        |            |              | (146,068 | )    |            |         | (88,037  | ) |            |        | (35,971 | )
|                                           |                               | Less mandatorily redeemable convertible
preferred stock dividends and accretion |            |              | (15,059  | )    |            |         | (3,644   | ) |            |        | (1,654  | )
|                                           |                               | Less deemed dividend related to beneficial
conversion feature                   |            |              | (9,356   | )    |            |         | (20,027  | ) |            |        |        |  
|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|                                           |                               | Net loss attributable to common stockholders                                    |            | $            | (170,483 | )    |            | $       | (111,708 | ) |            | $      | (37,625 | )
|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|Weighted average common shares outstanding |                               |                                                                                 | 33,908,374 |              |          |      | 33,066,538 |         |          |   | 15,099,359 |       
|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       
|Basic and diluted net loss per share       |                               | $                                                                               | (5.03      | )            |          | $    | (3.38      | )       |          | $ | (2.49      | )     
|                                           |                               |                                                                                 |            |              |          |      |            |         |          |   |            |       

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

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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY (DEFICIT)
AND COMPREHENSIVE INCOME
(In thousands, except share data)



|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |         |  
|------------------------------------------------------------------------------------------------ | ------------------------------------------------- |  | ------------ | ------- | --------- | - | ------------ | - | ------------ | - | ---------------- | -- | -------- | - | ---------- | --- |  | - | ------- | ------- | -
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   | Notes Receivable |    | Unearned |   | Additional
|                                                                                                 |                                                   |  | Common Stock |         | from      |   | Stock        |   | Paid-In     
|                                                                                                 |                                                   |  | Shares       |         | Par Value |   | Stockholders |   | Compensation |   | Capital         
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                 
|Balances, December 31, 1998                                                                      |                                                   |  | 14,411,100   |         |           | $ | 144          |   |              | $ | (3,329           | )  |          | $ | (192       | )   |  | $ | 16,493  |        
|Issuance of common stock in Initial
Public Offering, net of underwriter
discount and commissions |                                                   |  | 6,900,000    |         |           |   | 69           |   |              |   |                  |    |          |   |            |     |  |   | 109,020 |        
|Cost of issuance of common stock in
Initial Public Offering                                      |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   | (1,693  | )      
|Issuance of common stock
for exercise of stock options                                           |                                                   |  | 306,555      |         |           |   | 3            |   |              |   |                  |    |          |   |            |     |  |   | 535     |        
|Issuance of common stock
in exchange for services rendered                                       |                                                   |  | 55,000       |         |           |   | 1            |   |              |   |                  |    |          |   |            |     |  |   | 299     |        
|Issuance of common stock to
purchase assets                                                      |                                                   |  | 11,000       |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   | 60      |        
|Conversion of preferred stock to
common stock                                                    |                                                   |  | 10,476,256   |         |           |   | 105          |   |              |   |                  |    |          |   |            |     |  |   | 39,809  |        
|Grant of stock options
below intrinsic value                                                     |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   | (3,225     | )   |  |   | 4,768   |        
|Vesting of stock options granted
below intrinsic value                                           |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   | 930        |     |  |   |         |        
|Treasury stock received upon
cancellation of notes receivable
from stockholder                   |                                                   |  | (279,675     | )       |           |   |              |   |              |   | 318              |    |          |   |            |     |  |   |         |        
|Repayment of stockholders notes                                                                 |                                                   |  |              |         |           |   |              |   |              |   | 1,222            |    |          |   |            |     |  |   |         |        
|Forgiveness of stockholder note                                                                  |                                                   |  |              |         |           |   |              |   |              |   | 106              |    |          |   |            |     |  |   |         |        
|Accrued dividend on preferred stock                                                              |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   | (1,654  | )      
|Net loss                                                                                         |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|Balances, December 31, 1999                                                                      |                                                   |  | 31,880,236   |         |           |   | 322          |   |              |   | (1,683           | )  |          |   | (2,487     | )   |  |   | 167,637 |        
|Issuance of common stock for
acquisition or Touch 1                                              |                                                   |  | 1,100,000    |         |           |   | 11           |   |              |   |                  |    |          |   |            |     |  |   | 39,275  |        
|Issuance of common stock for exercise
of stock options                                           |                                                   |  | 773,999      |         |           |   | 7            |   |              |   |                  |    |          |   |            |     |  |   | 2,405   |        
|Repayment of stockholders notes                                                                 |                                                   |  |              |         |           |   |              |   |              |   | 844              |    |          |   |            |     |  |   |         |        
|Vesting of stock options granted below
intrinsic value                                           |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   | 2,232      |     |  |   | (2,621  | )      
|Warrants extinguished with debt                                                                  |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   | 655     |        
|Warrants issued for litigation
settlement                                                        |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   | 611     |        
|Mandatorily convertible redeemable
dividends and preferred stock
accretion                       |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   | (3,070  | )      
|Warrants issued with preferred stock                                                             |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   | 22,412  |        
|Net Loss                                                                                         |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|Foreign currency translation adjustment                                                          |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|Comprehensive Income                                                                             |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|Balances, December 31, 2000                                                                      |                                                   |  | 33,754,235   |         |           |   | 340          |   |              |   | (839             | )  |          |   | (255       | )   |  |   | 227,304 |        
|Issuance of common stock for exercise
of stock options                                           |                                                   |  | 254,731      |         |           |   | 3            |   |              |   | (820             | )  |          |   |            |     |  |   | 1,000   |        
|Issuance of common stock for exercise                                                            |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 | of warrants                                       |  |              | 25,714  |           |   |              |  |              |   |                  |   |          |   |            |    |  |   |         |        |  
|Issuance of common stock for the                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 | purchase of software                              |  |              | 27,500  |           |   |              |  |              |   |                  |   |          |   |            |    |  |   |         | 155     |  
|Vesting of stock options granted below                                                           |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 | intrinsic value                                   |  |              |        |           |   |              |  |              |   |                  |   |          |   |            | 133 |  |   |         |        |  
|Accelerated vesting of stock options                                                             |                                                   |  |             |         |           |   |             |   |              |   |                 |    |          |   |           |     |  |   | 49      |        
|Mandatorily convertible redeemable                                                               |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 | dividends and preferred stock
accretion           |  |              |        |           |   |              |  |              |   |                  |   |          |   |            |    |  |   |         | (15,059 | )
|Warrants issued with preferred stock                                                             |                                                   |  |             |         |           |   |             |   |              |   |                 |    |          |   |           |     |  |   | 4,333   |        
|Treasury stock received upon                                                                     |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 | cancellation of notes receivable
from stockholder |  |              | (61,875 | )         |   |              |  |              |   |                  | 70 |          |   |            |    |  |   |         |        |  
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|Net loss                                                                                         |                                                   |  |             |         |           |   |             |   |              |   |                 |    |          |   |           |     |  |   |        |        
|Foreign currency translation adjustment                                                          |                                                   |  |             |         |           |   |             |   |              |   |                 |    |          |   |           |     |  |   |        |        
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|Comprehensive loss                                                                               |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        
|Balance, December 31, 2001                                                                       |                                                   |  | 34,000,305   |         |           | $ | 343          |   |              | $ | (1,589           | )  |          | $ | (122       | )   |  | $ | 217,782 |        
|                                                                                                 |                                                   |  |              |         |           |   |              |   |              |   |                  |    |          |   |            |     |  |   |         |        

[Additional columns below]

[Continued from above table, first column(s) repeated]

|                                                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |          |         |  
|------------------------------------------------------------------------------------------------ | ------------------------------------------------- | - | ----------- | - | ------------- | - | ----------- | - | ---------------- | - | ---- | --- | ----- | - | -------- | ------- | -
|                                                                                                 |                                                   |   |             |   |               |   | Accumulated |   |                  |   |      |     |       |   |         
|                                                                                                 |                                                   |   |             |   |               |   | Other       |   |                  |   |      |     | Total
|                                                                                                 |                                                   |   | Accumulated |   | Comprehensive |   | Treasury    |   | Stockholders'   
|                                                                                                 |                                                   |   | Deficit     |   | Income        |   | Stock       |   | Equity (Deficit)
|                                                                                                 |                                                   |   |             |   |               |   |             |   |                 
|Balances, December 31, 1998                                                                      |                                                   | $ | (13,122     | ) |               | $ |            |   |                  | $ |     |     |       | $ | (6       | )      
|Issuance of common stock in Initial
Public Offering, net of underwriter
discount and commissions |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 109,089  |        
|Cost of issuance of common stock in
Initial Public Offering                                      |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | (1,693   | )      
|Issuance of common stock
for exercise of stock options                                           |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 538      |        
|Issuance of common stock
in exchange for services rendered                                       |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 300      |        
|Issuance of common stock to
purchase assets                                                      |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 60       |        
|Conversion of preferred stock to
common stock                                                    |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 39,914   |        
|Grant of stock options
below intrinsic value                                                     |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 1,543    |        
|Vesting of stock options granted
below intrinsic value                                           |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 930      |        
|Treasury stock received upon
cancellation of notes receivable
from stockholder                   |                                                   |   |             |   |               |   |             |   |                  |   | (318 | )   |       |   |         |        
|Repayment of stockholders notes                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 1,222    |        
|Forgiveness of stockholder note                                                                  |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 106      |        
|Accrued dividend on preferred stock                                                              |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | (1,654   | )      
|Net loss                                                                                         |                                                   |   | (35,971     | ) |               |   |             |   |                  |   |      |     |       |   | (35,971  | )      
|                                                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |          |        
|Balances, December 31, 1999                                                                      |                                                   |   | (49,093     | ) |               |   |            |   |                  |   | (318 | )   |       |   | 114,378  |        
|Issuance of common stock for
acquisition or Touch 1                                              |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 39,286   |        
|Issuance of common stock for exercise
of stock options                                           |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 2,412    |        
|Repayment of stockholders notes                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 844      |        
|Vesting of stock options granted below
intrinsic value                                           |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | (389     | )      
|Warrants extinguished with debt                                                                  |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 655      |        
|Warrants issued for litigation
settlement                                                        |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 611      |        
|Mandatorily convertible redeemable
dividends and preferred stock
accretion                       |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | (3,070   | )      
|Warrants issued with preferred stock                                                             |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 22,412   |        
|Net Loss                                                                                         |                                                   |   | (88,037     | ) |               |   |             |   |                  |   |      |     |       |   | (88,037  | )      
|Foreign currency translation adjustment                                                          |                                                   |   |             |   |               |   | (2          | ) |                  |   |      |     |       |   | (2       | )      
|                                                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |          |        
|Comprehensive Income                                                                             |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | (88,039  | )      
|                                                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |          |        
|Balances, December 31, 2000                                                                      |                                                   |   | (137,130    | ) |               |   | (2          | ) |                  |   | (318 | )   |       |   | 89,100   |        
|Issuance of common stock for exercise
of stock options                                           |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | 183      |        
|Issuance of common stock for exercise                                                            |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |         |        
|                                                                                                 | of warrants                                       |   |             |  |               |   |             |  |                  |   |      |    |       |   |          |        |  
|Issuance of common stock for the                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |         |        
|                                                                                                 | purchase of software                              |   |             |  |               |   |             |  |                  |   |      |    |       |   |          | 155     |  
|Vesting of stock options granted below                                                           |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |         |        
|                                                                                                 | intrinsic value                                   |   |             |  |               |   |             |  |                  |   |      |    |       |   |          | 133     |  
|Accelerated vesting of stock options                                                             |                                                   |   |            |   |               |   |            |   |                  |   |     |     |       |   | 49       |        
|Mandatorily convertible redeemable                                                               |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |         |        
|                                                                                                 | dividends and preferred stock
accretion           |   |             |  |               |   |             |  |                  |   |      |    |       |   |          | (15,059 | )
|Warrants issued with preferred stock                                                             |                                                   |   |            |   |               |   |            |   |                  |   |     |     |       |   | 4,333    |        
|Treasury stock received upon                                                                     |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |         |        
|                                                                                                 | cancellation of notes receivable
from stockholder |   |             |  |               |   |             |  |                  |   |      | (70 | )     |   |          |        |  
|                                                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |          |        
|Net loss                                                                                         |                                                   |   | (146,068    | ) |               |   |            |   |                  |   |     |     |       |   | (146,068 | )      
|Foreign currency translation adjustment                                                          |                                                   |   |            |   |               |   | 2           |   |                  |   |     |     |       |   | 2        |        
|                                                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |          |        
|Comprehensive loss                                                                               |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   | (146,066 | )      
|                                                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |          |        
|Balance, December 31, 2001                                                                       |                                                   | $ | (283,198    | ) |               | $ |            |   |                  | $ | (388 | )   |       | $ | (67,172  | )      
|                                                                                                 |                                                   |   |             |   |               |   |             |   |                  |   |      |     |       |   |          |        

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

F-5



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |         |        |         |  
|---------------------------------------------------- | ---------------------------------------------------------------------------- | ---------------------------------------------------- | ----------------------------------------- | ------- | ------------ | ------- | ------- | ------- | ------- | ------- | ------- | ------- | ------ | ------- | -
|                                                     |                                                                              |                                                      |                                           |         | Year Ended  
|                                                     |                                                                              |                                                      |                                           |         | December 31,
|                                                     |                                                                              |                                                      |                                           |         |             
|                                                     |                                                                              |                                                      |                                           |         | 2001         |         | 2000    |         | 1999   
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |        
|Cash
flows from operating activities:                |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|Net
loss                                             |                                                                              | $                                                    | (146,068                                  | )       |              | $       | (88,037 | )       |         | $       | (35,971 | )      
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|                                                     | Adjustments to reconcile net loss to net cash used in
operating activities:  |                                                      |                                           |         |              |         |         |         |         |         |         |         |       
|                                                     | Depreciation and amortization                                                |                                                      |                                           | 23,277  |              |         |         | 17,166  |         |         |         | 4,372   |       
|                                                     | Interest expense on capital lease obligation discount                        |                                                      |                                           |        |              |         |         |        |         |         |         | 2,192   |       
|                                                     | Provision for bad debts                                                      |                                                      |                                           | 55,530  |              |         |         | 17,804  |         |         |         | 958     |       
|                                                     | Asset impairment charge                                                      |                                                      |                                           | 59,247  |              |         |         |        |         |         |         |        |       
|                                                     | Expense charged for granting of stock options                                |                                                      |                                           | 182     |              |         |         | (389    | )       |         |         | 387     |       
|                                                     | Expense charged for granting of stock for services                           |                                                      |                                           |        |              |         |         |        |         |         |         | 300     |       
|                                                     | Expense charged for issuance of warrants for litigation settlement           |                                                      |                                           |        |              |         |         | 611     |         |         |         |        |       
|                                                     | Expense charged for issuance of warrants to extinguish debt                  |                                                      |                                           |        |              |         |         | 655     |         |         |         |        |       
|                                                     | (Gain) loss on disposal of assets                                            |                                                      |                                           | (329    | )            |         |         | (2,124  | )       |         |         |        |       
|                                                     | Change in operating assets and liabilities:                                  |                                                      |                                           |         |              |         |         |         |         |         |         |         |       
|                                                     |                                                                              | Increase in accounts receivable                      |                                           |         | (17,140      | )       |         |         | (71,581 | )       |         |         | (5,188 | )      
|                                                     |                                                                              | Increase (decrease) in prepaid expenses              |                                           |         | 1,106        |         |         |         | (5,594  | )       |         |         | (1,881 | )      
|                                                     |                                                                              | Increase (decrease) in other assets                  |                                           |         | (1,074       | )       |         |         | (995    | )       |         |         | (769   | )      
|                                                     |                                                                              | Increase in accounts payable and accrued liabilities |                                           |         | 5,138        |         |         |         | 28,473  |         |         |         | 2,402  |        
|                                                     |                                                                              | Increase
(decrease) in deferred revenue              |                                           |         | (1,715       | )       |         |         | 7,149   |         |         |         | 517    |        
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|                                                     |                                                                              |                                                      | Total adjustments                         |         |              | 124,222 |         |         |         | (8,825  | )       |         |        | 3,290   |  
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|                                                     |                                                                              |                                                      | Net cash used in operating activities     |         |              | (21,846 | )       |         |         | (96,862 | )       |         |        | (32,681 | )
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|Cash
flows from investing activities:                |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|                                                     | Proceeds from sale and leaseback transaction                                 |                                                      |                                           |        |              |         |         |        |         |         |         | 15,969  |       
|                                                     | Proceeds from notes receivable                                               |                                                      |                                           | 7       |              |         |         | 766     |         |         |         |        |       
|                                                     | Proceeds from sale of securities                                             |                                                      |                                           |        |              |         |         | 3,486   |         |         |         |        |       
|                                                     | Issuance of notes receivable                                                 |                                                      |                                           | (196    | )            |         |         |         |         |         |         |         |       
|                                                     | Purchases of property and equipment                                          |                                                      |                                           | (15,426 | )            |         |         | (34,849 | )       |         |         | (21,151 | )     
|                                                     | Purchase of securities                                                       |                                                      |                                           |        |              |         |         | (1,050  | )       |         |         |        |       
|                                                     | Purchase of Touch 1, net of cash acquired                                    |                                                      |                                           |        |              |         |         | (8,955  | )       |         |         |        |       
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|                                                     |                                                                              |                                                      | Net cash used in investing activities     |         |              | (15,615 | )       |         |         | (40,602 | )       |         |        | (5,182  | )
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|Cash
flows from financing activities:                |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|                                                     | Proceeds from issuance of mandatorily
redeemable convertible preferred stock |                                                      |                                           | 17,500  |              |         |         | 106,260 |         |         |         | 24,950  |       
|                                                     | Payment of issuance cost for mandatorily redeemable
preferred stock          |                                                      |                                           | (450    | )            |         |         | (1,464  | )       |         |         |        |       
|                                                     | Proceeds from issuance of initial public offering, net of underwriters      |                                                      |                                           |         |              |         |         |        |         |         |         |         |       
|                                                     |                                                                              |                                                      | discount and commissions                  |         |              |        |         |         |         |        |         |         |        | 109,089 |  
|                                                     | Payment of issuance cost of initial public offering                          |                                                      |                                           |        |              |         |         |        |         |         |         | (1,693  | )     
|                                                     | Proceeds from exercise of stock options                                      |                                                      |                                           | 183     |              |         |         | 2,412   |         |         |         | 538     |       
|                                                     | Proceeds from notes receivable                                               |                                                      |                                           |        |              |         |         | 844     |         |         |         | 1,222   |       
|                                                     | Payments on long-term debt obligations                                       |                                                      |                                           | (7,532  | )            |         |         | (8,853  | )       |         |         | (565    | )     
|                                                     | Payments on capital lease obligations                                        |                                                      |                                           |        |              |         |         | (14,031 | )       |         |         | (1,994  | )     
|                                                     | Payments of preferred stock dividends                                        |                                                      |                                           |        |              |         |         | (2,713  | )       |         |         |        |       
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|                                                     |                                                                              |                                                      | Net cash provided by financing activities |         |              | 9,701   |         |         |         | 82,455  |         |         |        | 131,547 |  
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|                                                     | Adjustments for foreign currency translation                                 |                                                      |                                           | 2       |              |         |         | 2       |         |         |         |        |       
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|Net increase (decrease) in cash and cash equivalents |                                                                              |                                                      | (27,758                                   | )       |              |         | (55,007 | )       |         |         | 93,684  |        
|Cash and cash equivalents, beginning of period       |                                                                              |                                                      | 46,650                                    |         |              |         | 101,657 |         |         |         | 7,973   |        
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        
|Cash and cash equivalents, end of period             |                                                                              | $                                                    | 18,892                                    |         |              | $       | 46,650  |         |         | $       | 101,657 |        
|                                                     |                                                                              |                                                      |                                           |         |              |         |         |         |         |         |         |        

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

F-6



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

|                                                  |                                                                               |                                              |   |              |   |      |   |        |        |  |   |        |   | 
|------------------------------------------------- | ----------------------------------------------------------------------------- | -------------------------------------------- | - | ------------ | - | ---- | - | ------ | ------ |  | - | ------ | - | 
|                                                  |                                                                               |                                              |   | Year Ended  
|                                                  |                                                                               |                                              |   | December 31,
|                                                  |                                                                               |                                              |   |             
|                                                  |                                                                               |                                              |   | 2001         |   | 2000 |   | 1999  
|                                                  |                                                                               |                                              |   |              |   |      |   |       
|Supplemental
disclosure of cash flow information: |                                                                               |                                              |   |              |   |      |   |        |        |  |   |       
|                                                  | Cash paid for interest                                                        |                                              | $ | 2,648        |   |      | $ | 1,592  |        |  | $ | 1,130  |  
|                                                  |                                                                               |                                              |   |              |   |      |   |        |        |  |   |       
|Non-cash
investing and financing activities:      |                                                                               |                                              |   |              |   |      |   |        |        |  |   |       
|                                                  | Property and equipment acquired under capital lease obligations               |                                              | $ | 2,395        |   |      | $ |       |        |  | $ | 15,944 |  
|                                                  | Increase in additional paid-in capital for stock options granted              |                                              | $ | 1,051        |   |      | $ | 2,405  |        |  | $ | 5,064  |  
|                                                  | Net increase in unearned stock compensation for stock options granted         |                                              | $ | 133          |   |      | $ | 2,232  |        |  | $ | 2,295  |  
|                                                  | Accrued dividends and accretion on preferred stock                            |                                              | $ | 15,059       |   |      | $ | 3,644  |        |  | $ | 1,654  |  
|                                                  | Notes receivable issued for common stock                                      |                                              | $ | 820          |   |      | $ |       |        |  | $ |       |  
|                                                  | Forgiveness of note receivable issued for common stock                        |                                              | $ | (70          | ) |      | $ |       |        |  | $ | (106   | )
|                                                  | Common stock issued for purchase of assets                                    |                                              | $ | 155          |   |      | $ |       |        |  | $ | 60     |  
|                                                  | Treasury stock received upon cancellation of note receivable
for common stock |                                              | $ | (70          | ) |      | $ |       |        |  | $ | (318   | )
|                                                  | Conversion of preferred stock to common stock                                 |                                              | $ |             |   |      | $ |       |        |  | $ | 39,914 |  
|                                                  | Beneficial conversion associated with preferred stock issuance                |                                              | $ | 9,356        |   |      | $ | 20,027 |        |  | $ |       |  
|                                                  | Warrants extinguished with satisfaction of debt                               |                                              | $ |             |   |      | $ | 655    |        |  | $ |       |  
|                                                  | Warrants issued in litigation settlement                                      |                                              | $ |             |   |      | $ | 611    |        |  | $ |       |  
|                                                  | Acquisition of Touch 1                                                        |                                              |   |              |   |      |   |        |        |  |   |        |  
|                                                  | Assets acquired, net of cash                                                  |                                              | $ |             |   |      | $ | 85,967 |        |  | $ |       |  
|                                                  |                                                                               | Liabilities assumed                          |   | $            |  |      |   | $      | 37,979 |  |   | $      |  | 
|                                                  |                                                                               | Cash acquired                                |   | $            |  |      |   | $      | 1,168  |  |   | $      |  | 
|                                                  |                                                                               | Assets acquired in exchange for common stock |   | $            |  |      |   | $      | 40,201 |  |   | $      |  | 

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

F-7



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(All tables are in thousands, except for share and per share data)



| |  | 1. | NATURE OF BUSINESS

Description of Business
| |  | -- | -------------------------------------------



| |  |  | Z-Tel Technologies, Inc. and subsidiaries (Z-Tel or the Company)
incorporated in Delaware on January 15, 1998 as Olympus
Telecommunications Group, Inc. In March 1998, Olympus Telecommunications
Group, Inc. changed its name to Z-Tel Technologies, Inc.
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Z-Tel is an emerging provider of advanced, integrated telecommunications
services targeted to residential and small business subscribers. Z-Tel
offers local and long distance telephone services in combination with
enhanced communication features accessible through the telephone the
Internet and certain personal digital assistants. Z-Tel offers its
Z-LineHOME service in thirty-eight states. Z-Tel actively markets Z-Line HOME in ten states. Z-Tel also provides long-distance
telecommunications services to customers nationally.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The Company has incurred significant losses since its inception,
resulting in an accumulated deficit at December 31, 2001 of approximately
$283 million. The Company also has long-term debt outstanding of
approximately $16 million. The Company continues to experience negative
cash flows from operations, which has historically caused it to be
dependent on financing from investors to sustain its activities. Within
the last two years, the Company raised net proceeds of approximately $109.1 million from
its initial public offering and approximately $122.0 million from
offerings of mandatorily redeemable convertible preferred stock.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  |  | At December 31, 2001, the Company had cash on hand of approximately $19.0
million. In addition, the Company has an accounts receivable factoring
agreement, which provides the Company with up to $25 million dollars to
fund operations. This factoring agreement, although renewable for
one-year terms, contractually terminates in July 2002. The Company
currently anticipates extending the term of the agreement; however, the
extension cannot be assured. Currently, the Company anticipates
generating, through normal operations, the cash flows necessary to meet
its operating and debt service requirements. If actual results differ
materially from the Company's current plan, or if the accounts receivable
factoring agreement is not renewed, management believes they have the
ability to continue as a going-concern through the implementation of cash
management strategies, the reduction of certain discretionary capital and
marketing costs or the implementation of a workforce reduction. The
Company also may seek additional financing to replace the current
factoring agreement. There can be no assurance, however, that the
Company will be able to implement its strategies or obtain additional
financing under terms favorable to the Company.



| |  | 2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation
| |  | -- | -----------------------------------------------------------------------



| |  |  | The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All intercompany accounts and
transactions have been eliminated.
| |  |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-8



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------
| | Cash and Cash Equivalents                                                                                                       
|
| | The Company considers all highly liquid investments with original
maturity dates of three months or less to be cash equivalents.



| |                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Prepaid Expenses and Other Current Assets                                                                                                                                                                                
|
| | Prepaid expenses and other current assets consist primarily of prepaid
maintenance and support contracts, advances to suppliers and certain
disputes with vendors that require payment and the filing of a dispute
claim.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Property and Equipment                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|
| | Property and equipment are recorded at historical cost. Depreciation and
amortization are calculated on a straight-line basis over the assets
useful life. Maintenance and repairs are expensed as incurred, while
renewals and betterments are capitalized. Upon the sale or other
disposition of property, the cost and related accumulated depreciation
are removed from the accounts and any gain or loss is recognized in
operations. Effective January 1, 1999, the Company adopted Statement of
Position (SOP) 98-1, Accounting for the Cost of Computer Software
Developed or Obtained for Internal Use. SOP 98-1 requires computer
software costs related to internal software that is incurred in the
preliminary project stage to be expensed as incurred. When the
capitalization criteria of SOP 98-1 have been met, costs of developing or
obtaining internal-use computer software are capitalized. The Company
capitalized approximately $3.9 and $3.1 million of employee salary costs
for internally developed software for the years ended December 31, 2001
and 2000, respectively. Internal use software is included as a component
of property and equipment on the consolidated balance sheet.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Long-Lived Assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|
| | The Company reviews long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Recoverability of assets to be held and used is
measured by a comparison of the carrying amount of an asset to future net
undiscounted cash flows expected to be generated by the asset. If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds
the discounted cash flows. The Company recognized an impairment of $59.2
million related to goodwill acquired from the acquisition of Touch 1 as a
result of the sale of our telemarketing centers in 2001. As stated under
New Accounting Pronouncements, the Company adopted Statement of
Financial Accounting Standard (SFAS) No. 144 effective January 1, 2002.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Intangible Assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|
| | Intangible assets consist of customer lists and goodwill resulting from
our acquisition of Touch 1 in 2000 (see Footnote 3  Acquisition of Touch 1). The
customer lists and goodwill are amortized over five and twenty years,
respectively, using the straight-line method and the intangibles are
reviewed for impairment as outlined in our long-lived assets policy
above. The goodwill was written-down to zero value in 2001. As noted
under New Accounting Pronouncements, the Company adopted SFAS No. 142
effective January 1, 2002.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Investments                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| | Included in investments are available-for-sale securities and investments
accounted for utilizing the cost method of accounting, for those
investments without a readily identifiable market. In accordance with
SFAS No. 115, Accounting for Certain Investments in Debt and Equity
Securities securities that are available for sale are reported at fair
value, if a readily identifiable market exists, with changes in the fair

F-9



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | value from period to period included as a separate component of
comprehensive income in equity. At December 31, 2000 the Company had
approximately $0.4 million in investments, included in other assets,
accounted for at cost since no readily identifiable market existed for
these investments. Z-Tel received gross proceeds of approximately $3.5
million and recognized a gain on available for sale securities in the
amount of approximately $2.7 million for the year ended December 31,
2000. The Company had no investments or sales of investments for the
years ended December 31, 2001 and 1999.
| |  |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Income Taxes
| |  |  | ------------



| |  |  | The Company utilizes the asset and liability method of accounting for
income taxes. Under this method, deferred income taxes are recorded to
reflect the tax consequences on future years of differences between the
tax basis of assets and liabilities and their financially reported
amounts at each year-end based on enacted laws and statutory rates
applicable to the periods in which differences are expected to affect
taxable income. A valuation allowance is provided against the future
benefits of deferred tax assets if it is determined that it is more
likely than not that the future tax benefits associated with the deferred
tax asset will not be realized.
| |  |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Stock-Based Compensation
| |  |  | ------------------------



| |  |  | The Company applies the provisions of Accounting Principles Board (APB)
Opinion No. 25 and consequently recognizes compensation expense over the
vesting period for grants made to employees and directors only if, on the
measurement date, the market price of the underlying stock exceeds the
exercise price. For stock options granted to non-employees, the Company
utilizes the Emerging Issues Task Force (EITF) 96-18, Account for
Equity Instruments that are Issued to Other Than Employees Acquiring or
in Conjunction with Selling Goods or Services. The Company recognizes
expense over the vesting period of the grants made to non-employees based
on utilizing the Black-Sholes stock valuation model to calculate the value
of the option on the measurement date.
| |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | For employee stock options the Financial Accounting Standards Board
(FASB) issued SFAS No. 123, Accounting for Stock-Based Compensation
requiring entities to recognize as an expense, over the vesting period,
the fair value of the options or utilize the accounting for employee
stock options used under APB 25. Therefore, under SFAS 123 the Company
provides the required pro forma net income and earnings per share
disclosures for grants made as if the fair value method defined in SFAS
No. 123 had been applied.                                                                                                                                                                                                                                                        



| |  |  | Revenue Recognition
| |  |  | -------------------



| |  |  | Revenues are recognized when earned. Revenues related to long distance
and carrier access service charges are billed monthly in arrears, and the
associated revenues are recognized in the month of service. In June 1999,
the Company began offering its bundled service, Z-LineHOME, to consumers.
Charges for Z-LineHOME service are billed monthly in advance and the
Company recognizes revenues for this service ratably over the service
period, which management believes approximates the actual provision of
services.
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Advertising
| |  |  | -----------



| |  |  | Advertising costs are expensed as incurred. Included in sales and
marketing expenses are advertising costs of approximately $7.1, $8.4 and
$7.1 million for the years ended December 31, 2001, 2000 and 1999,
respectively.
| |  |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Foreign Currency Translation
| |  |  | ----------------------------



| |  |  | The assets and liabilities of the Companys foreign subsidiary, whose
functional currency is other than the U.S. Dollar, are translated at the
exchange rates in effect on the reporting date, and income and expenses
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-10



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | are translated at the weighted average exchange rate during the period.
The net effect of translation gains and losses is not included in
determining net income but is included in accumulated other comprehensive
income, which is reflected as a separate component of shareholders
equity. Foreign currency translation gains and losses are included in
determining net income. Such gains and losses are not material for any
period presented. The Companys only foreign subsidiary was sold during
2001.
| |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Concentrations
| |  |  | --------------



| |  |  | Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and cash
equivalents and accounts receivable. The Company places its cash and cash
equivalents in financial institutions considered by management to be high
quality. The Company maintains cash balances at financial institutions in
excess of the $100,000 insured by the Federal Deposit Insurance
Corporation ("FDIC"). The Company had approximately $8.1 and $42.9 million
invested in interest bearing money market and short-term fixed income
investments that are not insured by the FDIC at December 31, 2001 and
2000, respectively. The Company has not experienced any losses in these
accounts and believes it is not exposed to any significant credit risk on
cash balances.
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | During the normal course of business, the Company extends credit to
residential customers residing in the United States. The Companys
services were introduced first into the states of New York and Texas,
which has resulted in a concentration of credit to residential customers
in these states. The Company believes its credit policies, collection
procedures and allowance for doubtful accounts minimize the exposure to
significant credit risk of accounts receivable balances.                                                                                                                                                                                                                                                                                                                          
|
| |  |  | The Company relies upon the Regional Bell Operating Companies (RBOCs)
for provisioning of customers and the RBOCs are the primary suppliers of
local central office switching and local telephone lines. Global Crossing
Ltd is the primary supplier for the Companys long-distance calling. The
Company has not incurred any material impact to its operations or
financial statements as a result of the Global Crossing Ltd. Chapter 11
bankruptcy filing.                                                                                                                                                                                                                                                                                                                                                      
|
| |  |  | The Company relies upon two separate service providers for provisioning
and billing services essential to support the Companys operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           



| |  |  | Segment Reporting
| |  |  | -----------------



| |  |  | SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information, requires that the Company report financial and descriptive
information about reportable segments, and how these segments were
determined. The Company determines the allocation and performance of
resources based on total operations. Based on these factors, management
has determined that the Company operates as one segment as defined by
SFAS No. 131 during all periods presented.
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Financial Instruments
| |  |  | ---------------------



| |  |  | The recorded amounts of cash and cash equivalents approximate fair value
due to the short-term nature of these instruments. The Company has
determined that due to the interest rates and short-term nature of the
capital lease obligation, the fair value approximates the value recorded.
The Company has determined that the long-term debt assumed through
acquisition is recorded at fair value. The interest rates were adjusted
to the current market rate for purchase accounting treatment and the
Company believes the debt is properly recorded at fair value.
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-11



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | Managements Use of Estimates                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to
make estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements. Estimates also affect the reported
amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|
| |  |  | New Accounting Pronouncements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|
| |  |  | In July 2001, the FASB issued SFAS No. 141, Business Combinations and
SFAS No. 142, Goodwill and Other Intangible Assets. SFAS 141 addresses
the initial recognition and measurement of goodwill and other intangible
assets acquired in a business combination. SFAS No. 142 addresses the
initial recognition and measurement of intangible assets acquired outside
of a business combination, whether acquired individually or with a group
of other assets, and the accounting and reporting for goodwill and other
intangible assets subsequent to their acquisition. These standards
require all future business combinations to be accounted for using the
purchase method of accounting. Goodwill will no longer be amortized
regularly but instead will be subject to impairment tests at least
annually. The Company adopted SFAS No. 141 and SFAS No. 142 on a
prospective basis as of January 1, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|
| |  |  | As of December 31, 2001, Z-Tel has $5.9 million of intangible assets, net
of accumulated amortization. The net amount recorded for goodwill is
zero at December 31, 2001. Accordingly, the Company does not expect the
adoption of SFAS No. 142 to have a material impact on its future
operations and statement of position.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|
| |  |  | In June 2001, the FASB issued SFAS No. 143, Accounting for Asset
Retirement Obligations. The statement provides accounting and reporting
standards for recognizing obligations related to asset retirement costs
associated with the retirement of tangible long-lived assets. Under this
statement, legal obligations associated with the retirement of long-lived
assets are to be recognized at their fair value in the period in which
they are incurred if a reasonable estimate of fair value can be made.
The fair value of the asset retirement costs is capitalized as part of
the carrying amount of the long-lived asset and subsequently allocated to
expense using a systematic and rational method over the assets useful
life. Any subsequent
changes to the fair value of the liability due to passage of time or
changes in the amount or timing of estimated cash flows is recognized as
an accretion expense. The Company will be required to adopt this
statement no later than January 1, 2003. The Company is currently
assessing the impact of this statement on its results of operations,
financial position and cash flows.                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  |  | In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which is effective for
fiscal years beginning after December 15, 2001. This statement
supercedes FASB Statement No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. However,
SFAS 144 retains the fundamental provisions of SFAS No. 121 for the
recognition and measurement of the impairment of long-lived assets to be
held and used and the measurement of long-lived assets to be disposed of
by sale. Impairment of Goodwill is not included in the scope of SFAS No.
144 and will be treated in accordance with the accounting standards
established in SFAS No. 142, Goodwill and Other Intangible Assets.
According to SFAS No. 144, long-lived assets are to be measured at the
lower of carrying amount or fair value less cost to sell, whether
reported in continuing or discontinued operations. The statement applies
to all long-lived assets, including discontinued operations, and replaces
the provisions of APB Opinion 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, for the disposal of segments of a business. The
Company adopted this statement on January 1, 2002 on a prospective basis.
The adoption of this standard did not have a material impact on its results
of operations, financial position and cash flows.

F-12



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | Reclassification                                                                                                                               
| |  |  | -----------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Certain amounts in the December 31, 2000 and 1999 financial statements
have been reclassified to conform to the December 31, 2001 presentation.



| |                           
| | --------------------------
| | 3.  ACQUISITION OF TOUCH 1



| |  |  | The Company completed the acquisition of Touch 1 Communications, Inc.
(Touch 1), a reseller of long distance service to subscribers
throughout the United States, on April 14, 2000. The purchase price for
Touch 1 consisted of 1.1 million shares of the Companys common stock at
a price of $35.71 per share, approximately $9.0 million in cash, and
approximately $1.0 million in transaction and related fees. The
acquisition of Touch 1 was accounted for using the purchase method of
accounting and, accordingly, the results of operations of Touch 1 for the
period from April 1, 2000 (the closing date for accounting purposes) are
included in the accompanying consolidated financial statements. The
acquisition of Touch 1 resulted in approximately $67.8 million of
intangible assets. The intangible assets were comprised of approximately
$9.2 million for customer lists and approximately $58.6 million for
goodwill, which were being amortized, on the straight line basis, over
periods of five and twenty years, respectively. As disclosed in Footnote
7  Asset Impairment, during 2001, the Company recorded an impairment of
assets acquired of approximately $59.2 million, approximately $54.9
million related to goodwill associated with the Touch 1 purchase. The
Company recorded $3.3 and $3.6 million of amortization of the intangible
assets for the year ended December 31, 2001 and 2000, respectively.
| |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Touch 1 and its wholly owned
subsidiary, direcTEL Inc. (direcTEL), filed a voluntary
petition for relief under Chapter 11 of the Bankruptcy Code on June 29,
1999 and July 9, 1999, respectively, in the United States Bankruptcy
Court for the Southern District of Alabama (the Bankruptcy Court). The
Bankruptcy Court entered an order confirming the joint plan of
reorganization of Touch 1 and direcTEL on August 6, 1999 and entered
final decrees closing the direcTEL case on October 5, 2000 and the Touch
1 case on October 30, 2000.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  



| |                                  
| | ---------------------------------
| | 4.  ACCOUNTS RECEIVABLE AGREEMENT



| |  |  | In July 2000, the Company entered into an accounts receivable agreement
with RFC Capital Corporation, a division of Textron, Inc. (RFC),
providing for the sale of certain of the Companys accounts receivable to
RFC. RFC has agreed to purchase up to $25.0 million of the Companys
accounts receivable. In July 2001, the Company extended its agreement
with RFC under substantially similar terms for an additional year. The
RFC agreement, although renewable for one-year terms, contractually
terminates in July 2002. The purchase of the receivables is at the
option of RFC and they utilize selection criteria to determine which
receivables will be purchased. The Company sells receivables to RFC at a
32% discount; this rate is negotiable and may change according to
collection experience. Our collection percentage for receivables sold to
RFC was 89% for the year ended December 31, 2001. The Company receives
an additional payment from RFC for servicing the assets in an amount
equal to every dollar collected over the advance rate, less certain fees.
The accounts receivable agreement does not have a minimum receivable
sales requirement.
| |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Z-Tel has sold approximately $156.3 and $1.4 million of receivables
to RFC, for net proceeds of approximately $106.5 and $0.8 million, for
the years ended December 31, 2001 and 2000, respectively. A net
receivable servicing asset of approximately $12.9 and $0.4 million is
included in the accounts receivable balance at December 31, 2001 and
2000, respectively. The Company recorded costs related to the agreement
of approximately $1.1 million for the year ended December 31, 2001.
Included in accounts payable and accrued liabilities are advances for
unbilled receivables in the amount of $3.5 million at December 31, 2001.
Z-Tel is responsible for the continued servicing of the receivables sold.                                                                                                                                                                                                                                                                                                                                                                                                                                                          

F-13



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |                                  
| | ---------------------------------
| | 5.  ACCOUNTS RECEIVABLE WRITE-OFF



| |  |  | During the second quarter of 2001, management performed a detailed
analysis of accounts receivable and also reviewed its credit policies
relating specifically to acceptance and provisioning of service to new
customers. As a result of the analysis and subsequent change in credit
policy, the Company switched its focus from collection efforts on overdue
and delinquent account balances to a stringent credit policy surrounding
customer acceptance and a collection effort focused on fewer delinquent
accounts. The detailed analysis and
change in credit policy lead the Company to write-off delinquent
receivables and revise the estimates used to develop the allowance for
doubtful accounts in the current and future periods.
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | As a result of the receivables write-off, an additional approximately
$29.9 million of bad debt expense was recorded in the second quarter of
2001 and is included in general and administrative expense for the year
ended December 31, 2001. The Company had write-offs of accounts
receivables totaling approximately $43.9 and $21.2 million for the years
ended December 31, 2001 and 2000, respectively.                                                                                                                                                                                                                                                                                                                                    



| |                           
| | --------------------------
| | 6.  PROPERTY AND EQUIPMENT



| |  |  | At the respective dates, property and equipment consist of the following:
| |  |  | -------------------------------------------------------------------------

|                                               |  |                   |       |      |  |      |        |  |  |   |        | 
|---------------------------------------------- |  | ----------------- | ----- | ---- |  | ---- | ------ |  |  | - | ------ | 
|                                               |  | Depreciable Lives |       | 2001 |  | 2000
|                                               |  |                   |       |      |  |     
|Switching equipment                            |  |                   | 5-10  |      |  | $    | 14,589 |  |  | $ | 15,635 | 
|Computer equipment                             |  |                   | 5-10  |      |  |      | 28,263 |  |  |   | 25,068 | 
|Software                                       |  |                   | 3     |      |  |      | 35,462 |  |  |   | 23,832 | 
|Furniture and office equipment                 |  |                   | 5-10  |      |  |      | 9,537  |  |  |   | 9,174  | 
|Leasehold improvements                         |  |                   | 3-15  |      |  |      | 4,192  |  |  |   | 4,186  | 
|Land and building                              |  |                   | 20-30 |      |  |      | 6,611  |  |  |   | 4,123  | 
|Construction-in-progress                       |  |                   |       |      |  |      | 792    |  |  |   | 2,371  | 
|                                               |  |                   |       |      |  |      |        |  |  |   |        | 
|                                               |  |                   |       |      |  |      | 99,446 |  |  |   | 84,389 | 
|Less accumulated depreciation and amortization |  |                   |       |      |  |      | 43,215 |  |  |   | 25,189 | 
|                                               |  |                   |       |      |  |      |        |  |  |   |        | 
|                                               |  |                   |       |      |  | $    | 56,231 |  |  | $ | 59,200 | 
|                                               |  |                   |       |      |  |      |        |  |  |   |        | 



| |  |  | Depreciation expense related to property and equipment amounted to
approximately $11.5, $8.2 and $2.0 million for the years ended December
31, 2001, 2000 and 1999, respectively. Amortization expense related to
software amounted to approximately $8.5, $5.4 and $2.4 million for the
years ended December 31, 2001, 2000 and 1999, respectively.
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | At the respective dates, assets acquired under capital leases, included
in property and equipment, consist of the following:                                                                                                                                                                                                                        

|                                               |  |      |       |      |  |   |    | 
|---------------------------------------------- |  | ---- | ----- | ---- |  | - | -- | 
|                                               |  | 2001 |       | 2000
|                                               |  |      |       |     
|Software                                       |  | $    | 704   |      |  | $ |   | 
|Computer equipment                             |  |      | 1,288 |      |  |   |   | 
|Furniture and office equipment                 |  |      |      |      |  |   | 95 | 
|                                               |  |      |       |      |  |   |    | 
|                                               |  |      | 1,992 |      |  |   | 95 | 
|Less accumulated depreciation and amortization |  |      | 312   |      |  |   | 27 | 
|                                               |  |      |       |      |  |   |    | 
|                                               |  |      |       |      |  |   |    | 
|                                               |  | $    | 1,680 |      |  | $ | 68 | 
|                                               |  |      |       |      |  |   |    | 

F-14



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |                     
| | --------------------
| | 7.  ASSET IMPAIRMENT



| |  |  | In accordance with SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,
management assesses on an ongoing basis if there has been impairment in
the carrying value of its long-lived assets. As a result of managements
decision in the second quarter to reduce telemarketing efforts, a
majority of the operations and assets of telemarketing centers acquired
from Touch 1 were either voluntarily closed or sold. On June 30, 2001,
the telemarketing centers sold accounted for approximately $1.0 million
in property, plant and equipment. For these assets, the Company received
270,000 shares of preferred stock of the privately-held acquiring company
and a note receivable of approximately $0.5 million. The loss recorded
from this transaction equated to approximately $1.0 million.                                                                                                                                                                                                                                                                                                                                                                                                     
| |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | As a result of the decision to reduce telemarketing efforts noted above
and the subsequent transactions, management performed an assessment of
the value of the intangible assets recorded in the Touch 1 acquisition.
In the second quarter of 2001, it was determined that undiscounted future
cash flows over the remaining amortization period of certain intangible
assets indicated that the value assigned to the intangible asset might
not be recoverable. Therefore, the Company undertook an effort to
determine the amount of expense to be recorded relating to the
impairment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|
| |  |  | The carrying value of the goodwill and identifiable intangibles recorded
on the books approximated $61.7 million prior to the impairment analysis.
The Company calculated the fair value of the intangibles by performing a
discounted cash flow analysis related to the remaining assets acquired in
the Touch 1 purchase. As the Company determined that it would effectively
cease any telemarketing efforts in the future, the sole remaining assets
from the Touch 1 purchase were certain amounts of property, plant and
equipment and intangibles (consisting of customer lists and goodwill)
acquired in the Touch 1 transaction. Assuming a monthly attrition rate of
4.5% and a discount rate of 17.5% over an 18 month period, it was
determined that the remaining operations acquired from Touch 1 had a
liquidation value which approximated the carrying value of the customer
lists acquired from Touch 1. At June 30, 2001, the carrying value of the
identifiable intangibles associated with the customer lists was
approximately $6.8 million. Therefore, during the second quarter of 2001,
the Company recorded a loss of $54.9 million, the difference between the
carrying value of all intangibles and the carrying value of the customer
lists.
|
| |  |  | For the year ended December 31, 2001, the Company recorded an additional
$4.3 million of impaired asset charges, composed of $3.0 million relating
to unrealizable software and development projects, $0.9 million of
telemarketing property and equipment and $0.4 million of securities
deemed to be worthless. As of December 31, 2001, the Company has
approximately $5.9 million of net intangible assets related to customer
lists.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                



| |                 
| | ----------------
| | 8.  OTHER ASSETS



| |  |  | At the respective dates, other assets consist of the following:
| |  |  | ---------------------------------------------------------------

|                                      |  |      |       |      |  |   |       | 
|------------------------------------- |  | ---- | ----- | ---- |  | - | ----- | 
|                                      |  | 2001 |       | 2000
|                                      |  |      |       |     
|Deposits                              |  | $    | 3,625 |      |  | $ | 2,656 | 
|Certificates
of deposit, restricted   |  |      | 647   |      |  |   | 573   | 
|Interest
receivable from stockholders |  |      | 176   |      |  |   | 111   | 
|Other                                 |  |      | 218   |      |  |   | 413   | 
|                                      |  |      |       |      |  |   |       | 
|                                      |  | $    | 4,666 |      |  | $ | 3,753 | 
|                                      |  |      |       |      |  |   |       | 

F-15



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | The certificates of deposit are pledged as collateral on outstanding
letters of credit in the amount of approximately $0.6 million at December
31, 2001 and 2000, related to lease obligations on two of the Companys
office spaces.
| |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |                                             
| | --------------------------------------------
| | 9.  ACCOUNTS PAYABLE AND ACCRUED LIABILITIES



| |  |  | At the respective dates, accounts payable and accrued liabilities consist
of the following:
| |  |  | -------------------------------------------------------------------------------------------

|                                           |  |       |        |      |  |       |        | 
|------------------------------------------ |  | ----- | ------ | ---- |  | ----- | ------ | 
|                                           |  | 2001  |        | 2000
|                                           |  |       |        |     
|Trade accounts payable                     |  | $     | 33,602 |      |  | $     | 32,679 | 
|                                           |  | 2,070 |        |      |  | 3,982 |       
|Dividend payable to preferred shareholders |  |       | 4,128  |      |  |       |       | 
|Accrued
sales and use tax                  |  |       | 3,644  |      |  |       | 2,239  | 
|Accrued rent                               |  |       | 1,533  |      |  |       | 1,218  | 
|Other accrued liabilities                  |  |       | 4,645  |      |  |       | 4,575  | 
|                                           |  |       |        |      |  |       |        | 
|                                           |  | $     | 49,622 |      |  | $     | 44,693 | 
|                                           |  |       |        |      |  |       |        | 

F-16



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |                    
| | -------------------
| | 10.  LONG-TERM DEBT



| |  |  | Long-term debt consists of the following:
| |  |  | -----------------------------------------
|

|                                                                                                                                                                                                                                   |  |      |        |      |  |   |        |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------ | ---- |  | - | ------ | -
|                                                                                                                                                                                                                                   |  | 2001 |        | 2000
|Related Parties:                                                                                                                                                                                                                   |  |      |        |      |  |   |        |  
|Note Payable to Corman Elegre Capital L.L.C (Corman Elegre),
customer base pledged as collateral, balloon payment due May 2001, interest rate at
rate at prime plus one and one-half percent, which was 11% at
December 31, 2000 |  | $    |       |      |  | $ | 3,000  |  
|Note payable to Corman Elegre, customer base pledged as collateral
payable in monthly installments, due September, 2004, interest rate at 6%                                                                                       |  |      | 7,595  |      |  |   | 9,868  |  
|Note payable to First Revocable Trust of W. F. Corman, unsecured
payable in monthly installments, due September 2004, interest rate at 6%                                                                                          |  |      | 472    |      |  |   | 612    |  
|Note payable to James F. Corman, unsecured, payable in monthly
installments, due September 2004, interest rate at 6%                                                                                                               |  |      | 159    |      |  |   | 211    |  
|Unrelated Parties:                                                                                                                                                                                                                 |  |      |        |      |  |   |        |  
|Note payable to Franklin Investment Funds, unsecured, payable in monthly
installments, due September 2004, interest rate of 6%                                                                                                     |  |      | 3,271  |      |  |   | 4,250  |  
|Note payable to First National Bank of Atmore, unsecured, personally
guaranteed by James F. Corman, payable in monthly installments,
due September 2004, interest rate at 6%                                                       |  |      | 439    |      |  |   | 570    |  
|Notes payable to pre-petition creditors (trade vendors), unsecured,
payable in monthly installments, due September 2004, interest rate at 6%                                                                                       |  |      | 1,169  |      |  |   | 1,475  |  
|Notes payable to pre-petition creditors (trade vendors), priority
unsecured, payable in monthly installments, due September 2004 , interest
rate at 6%                                                                             |  |      | 304    |      |  |   | 417    |  
|                                                                                                                                                                                                                                   |  |      |        |      |  |   |        |  
|                                                                                                                                                                                                                                   |  |      | 13,409 |      |  |   | 20,403 |  
|Less: Current portion                                                                                                                                                                                                              |  |      | (4,880 | )    |  |   | (7,623 | )
|                                                                                                                                                                                                                                   |  |      |        |      |  |   |        |  
|                                                                                                                                                                                                                                   |  | $    | 8,529  |      |  | $ | 12,780 |  
|                                                                                                                                                                                                                                   |  |      |        |      |  |   |        |  



| |  |  | Operating Leases                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |  |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The Company has entered into various non-cancelable operating leases for
equipment and office space with monthly payments through the year 2009.
Included in general and administrative expense is rental expense relating
to operating leases of approximately $2.8, $1.7 and $1.6 million for the
years ended December 31, 2001, 2000 and 1999, respectively. Sales and
marketing expense includes $0.6 million of rental expense relating to
operating leases for both years ended December 31, 2001 and 2000.
|
| |  |  | Capital Leases                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  |  | The Company entered into various capital lease obligations during 2001
that had effective interest rates ranging from 8.0% to 10.7%, with three
capital leases remaining with payments through 2001.                                                                                                                                                                                                                                                                                                             
|
| |  |  | Future minimum lease payments under non-cancelable operating and capital
leases and long-term debt as of December 31, 2001 are as follows:                                                                                                                                                                                                                                                                                                                                                                       

F-17



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)

|                                                                                                                              |            |        |           |             |       |      |           |       |  |  |        |       | 
|----------------------------------------------------------------------------------------------------------------------------- | ---------- | ------ | --------- | ----------- | ----- | ---- | --------- | ----- |  |  | ------ | ----- | 
|                                                                                                                              |            |        |           |             |       |      | Capital   |       |  |  |       
|                                                                                                                              |            |        | Operating |             | Lease |      | Long-Term
|Year Ending December 31,                                                                                                      |            | Leases |           | Obligations |       | Debt
|                                                                                                                              |            |        |           |             |       |     
|                                                                                                                              | 2002       |        | $         | 3,475       |       |      | $         | 1,635 |  |  | $      | 4,880 | 
|                                                                                                                              | 2003       |        |           | 3,562       |       |      |           | 725   |  |  |        | 4,403 | 
|                                                                                                                              | 2004       |        |           | 3,654       |       |      |           | 343   |  |  |        | 4,063 | 
|                                                                                                                              | 2005       |        |           | 2,531       |       |      |           |      |  |  |        | 63    | 
|                                                                                                                              | 2006       |        |           | 1,389       |       |      |           |       |  |  |        |       | 
|                                                                                                                              | Thereafter |        |           | 3,879       |       |      |           |       |  |  |        |       | 
|                                                                                                                              |            |        |           |             |       |      |           |       |  |  |        |      
|Less
amount representing estimated executor costs (taxes, etc.), including
profit thereon, included in minimum lease payments |            |        |          |             |       |      | 99        |       |  |  |       |      
|                                                                                                                              |            |        |           |             |       |      |           |       |  |  |        |      
|Net minimum payments                                                                                                          |            |        | 18,490    |             |       |      | 2,604     |       |  |  | 13,409 |      
|                                                                                                                              |            |        |           |             |       |      |           |       |  |  |        |      
|Less amount representing interest on obligations under
capital lease                                                          |            |        |           |             |       |      | 246       |       |  |  |        |      
|                                                                                                                              |            |        |           |             |       |      |           |       |  |  |        |      
|Present
value of minimum lease payments (including approximately $1,425 due
within one year)                                  |            |        |           |             |       | $    | 2,358     |       |  |  |        |      
|                                                                                                                              |            |        |           |             |       |      |           |       |  |  |        |      



| |                                                        
| | -------------------------------------------------------
| | 11.  MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK



| |  |  | In January 2000, the Company paid $1.4, $0.2, and $0.2 million to the
Series A, B, and C Preferred shareholders, respectively, in satisfaction
of an 8% cumulative dividend as all shares were converted to common
stock.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | In July 2000, the Company filed a Certificate of Designation authorizing
the issuance of 5.0 million shares of $.01 par value Series D Convertible
Preferred Stock (Series D Preferred). The Company received aggregate
proceeds of approximately $56.3 million in connection with the sale of
4,688,247 shares of Series D Preferred at a price of $12.00. The deal
costs associated with the transaction were approximately $0.4 million.
The Series D Preferred is convertible at an original conversion price of
$12.00, which price is subject to adjustment for such items as; (i) a
dividend or distribution to common shareholders (whether such dividend or
distribution is in stock, securities or other property), (ii) a stock
split, (iii) a stock combination, (iv) a reclassification of the common
stock, (v) the issuance of stock or securities convertible into or
exercisable for common stock of the Company at a price that is less than
the adjusted conversion price and other events that would cause dilution
of ownership to the Series D Preferred stock. As a result of certain of
these events the conversion price at December 31, 2001 is $8.79. The
Series D Preferred is convertible into common stock at the option of the
holder (i.e., initially convertible on a one-for-one basis); however,
there are certain circumstances that provide for a forced conversion of
the stock by the Company. Series D Preferred is mandatorily redeemable in
2008, has an 8% cumulative dividend payable at times in cash and at times
in-kind with additional Series D Preferred and has certain liquidation
preferences and voting rights. Each purchaser of Series D Preferred
received a warrant to purchase a number of shares of Z-Tel common stock
equal to one-half of the amount of Series D Preferred purchased by such
investor. Each warrant is exercisable at a price of $13.80 per share
subject to certain adjustments that have lowered the exercise price to
$10.52 per share, at December 31, 2001.
|
| |  |  | In October 2000, the Company paid $0.9 million to the Series D Preferred
shareholders in satisfaction of the 8% cumulative dividend.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

F-18



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | In November 2000, the Company filed a Certificate of Designation
authorizing the issuance of approximately 6.3 million shares of $.01 par
value Series E Convertible Preferred Stock (Series E Preferred). The
Company received proceeds of approximately $50.0 million in connection
with the sale of 4,166,667 shares of Series E Preferred at a price of
$12.00. The purchaser of Series E Preferred received a warrant to
purchase a number of shares of Z-Tel common stock equal to one-half of
the amount of Series E Preferred purchased by such investor. These
warrants are exercisable at a price of $13.80 per share subject to
certain adjustments that have lowered the exercise price to $8.71 per
share, at December 31, 2001. Series E Preferred is convertible at an
original conversion price of $12.00, which price is subject to adjustment
for such items as (i) a dividend or distribution to common shareholders
(whether such dividend or distribution is in stock, securities or other
property), (ii) a stock split, (iii) a stock combination, (iv) a
reclassification of the common stock, (v) the issuance of stock or
securities convertible into or exercisable for common share of the
Company at a price that is less than the adjusted conversion price, and
(vi) other events that would cause dilution in the ownership of the
holders of the Series E Preferred stock. As a result of these events the
conversion price at December 31, 2001 is $8.42. The Series E Preferred is
convertible into common stock at the option of the holder (i.e.,
initially convertible on a one-for-one basis); however, there are certain
circumstances that provide for a forced conversion of the stock by the
Company. Series E Preferred is mandatorily redeemable 8 years from the
original issue date, has an 8% cumulative dividend payable in cash and
has certain liquidation preferences and voting rights.
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | In July 2001, the Company filed a Certificate of Designation authorizing
the issuance of 175 shares of Series G junior convertible preferred stock
(Series G Preferred). On July 2 and August 3, 2001, the Company issued
an aggregate of 175 shares of Series G Preferred for aggregate proceeds
of $17.5 million, initially convertible into 11,739,970 shares of common
stock, at a conversion price of $1.49, subject to adjustment for such
items as; (i) a dividend or distribution to common shareholders (whether
such dividend or distribution is in stock, securities or other property),
(ii) a stock split, (iii) a stock combination, (iv) a reclassification of
the common stock, (v) the issuance of stock or securities convertible
into or exercisable for common stock of the Company at a price that is
less than the adjusted conversion price and upon the occurrence of
certain other events that would cause dilution in the ownership of the
holders of the Series G Preferred. There is no change in the conversion
price at December 31, 2001. In conjunction with the issuance of the
Series G Preferred, the Company issued warrants to purchase 3,000,000
shares of common stock at an exercise price of $0.01 per share. The
Series G Preferred was redeemable on December 31, 2001 unless shareholder
approval was obtained. Once shareholder approval was obtained the Series
G Preferred is mandatorily redeemable 5 years from September 18, 2001.
The Series G Preferred has a 12% cumulative dividend, is convertible at
the option of the holder and has certain liquidation rights; however,
there are certain circumstances that provide for a automatic conversion
of the Series G Preferred.                                                                                                                                                                                                       
|
| |  |  | In accordance with generally accepted accounting principles, the Company
recorded a deemed dividend of approximately $2.3 million, which results
from the value assigned to the warrants and a beneficial conversion
feature associated with the Series G Preferred transaction. These deemed
dividends were originally accreted over an expected life through December
31, 2001 (the earliest redemption date). Once shareholder approval was
obtained on October 30, 2001, the remaining balance of $1.2 million has
been and will continue to be accreted over the remaining 5-year
redemption period.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| |  |  | As a result of certain anti-dilution clauses in the Series D Preferred
stock agreement, the issuance of Series G Preferred triggered an
additional beneficial conversion feature related to the Series D
Preferred agreement. The deemed dividend of approximately $7.8 million
was accreted immediately, in the third quarter of 2001.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|
| |  |  | In accordance with EITF 98-5, Accounting for Convertible Securities
with Beneficial Conversion Features or Contingently Adjustable Conversion
Ratios, APB Opinion No. 14, Accounting for Convertible Debt and Debt
Issued with Stock Purchase Warrants, EITF 00-27, Application of Issue
No. 98-5 to Certain Convertible Instruments and SFAS No. 128 Earnings
Per Share the Company has recorded non-cash charges relating to a
beneficial conversion, cumulative dividends and preferred stock
accretion. The                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

F-19



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | Company recorded preferred stock dividends and accretion of $15.1, $3.6,
and $1.7 million for the years ended December 31, 2001, 2000 and 1999,
respectively. The Company recorded a deemed dividend related to a
beneficial conversion feature in the amounts of approximately $9.4,
$20.0 and $0.0 for the years ended December 31, 2001, 2000 and 1999,
respectively.                                                                                                                                                                                                                                                                                                                                                                                                                               
| |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | During the year ended December 31, 2000 the Company used the stated
conversion price method, included in EITF 98-5, for the original
calculation of a beneficial conversion of approximately $7.4 million
during the third quarter of 2000. The beneficial conversion related to
the issuance of Series D Preferred. EITF 98-5 allowed for the usage of
the stated conversion price method for the purpose of calculating
beneficial conversions until the fourth quarter of 2000. In November
2000, EITF 00-27, required that all beneficial conversions be calculated
using the accounting conversion price method. Z-Tel recorded a
cumulative catch-up adjustment of approximately $12.6 million in the
fourth quarter of 2000 since the SEC required retroactive application of
this method.
|
| |  |  | The recording of the beneficial conversion feature and the resulting
preferred stock accretion is the result of calculating the accounting
conversion price through a fair value allocation of the net proceeds
received in the preferred stock offerings between the preferred stock and
the warrants issued. This required the use of the Black-Scholes valuation
model to calculate the fair value on a per share or warrant basis for
both the Series D, E and G Preferred. The beneficial conversion and
resulting preferred stock accretion and the cumulative dividend are
included in the calculations of the net loss attributable to common
stockholders and the Companys net loss per share calculation.                                                                                   



| |                  
| | -----------------
| | 12.  COMMON STOCK



| |  |  | In connection with the closing of the IPO, the Company amended its
Articles of Incorporation to provide the authority to issue 150,000,000
shares of common stock and 50,000,000 shares of preferred stock, both
with a $.01 par value.                                                                                                                                                                                                                                                                                                                   
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | The board of directors has declared no dividends on common stock since
January 15, 1998 (Inception).                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|
| |  |  | On December 15, 1999, the Company filed its initial public offering (IPO)
of 6,900,000 shares (including the underwriters over-allotment option)
of its common stock at $17.00 per share. Net proceeds to the Company
aggregated approximately $109.1 million after underwriter discount and
commissions. All of the mandatorily redeemable convertible preferred
stock outstanding at the date of the IPO was converted into 10,476,256
shares of common stock as of the closing date of the offering.                                                  
|
| |  |  | On February 19, 2001, the Board of Directors of the Company adopted a
Stockholders Rights Agreement (the Plan) designed to deter coercive
takeover tactics and prevent an acquirer from gaining control of the
Company without engaging in negotiation with the Board of Directors of
the Company.                                                                                                                                                                                                                                                      
|
| |  |  | Under the terms of the plan, preferred stock purchase rights were
distributed as a dividend at the rate of one right for each share of
common stock, par value $0.01 per share, of the Company (and a
corresponding number of rights for each outstanding share of the
Companys Series D Preferred and Series E Preferred Stock) outstanding at
the close of business on March 7, 2001. Until the rights become
exercisable, additional common stock or Series D Preferred or Series E
Preferred issued by the Company will also have one right attached.
|
| |  |  | The rights will become exercisable only upon certain triggering events
whereby certain persons or groups of persons have expressed the
intent to acquire at least 15% or more of the voting power of the
outstanding common shares.                                                                                                                                                                                                                                                                                                                       

F-20



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | Upon the occurrence of a triggering event, each right will entitle
holders to buy one one-thousandth of a share of Series F Junior
Participating Preferred Stock of the Company, par value $0.001 per share,
at an exercise price of $45 per one-thousandth of a share, subject to
adjustment. Each holder of a right will thereafter have the right to
receive, in lieu of Series F Junior Participating Preferred Stock and
upon payment of the exercise price, common stock (or in certain
circumstances, cash, property or other securities of the Company) having
a value equal to two times the exercise price of the right. The Company,
except as otherwise provided in the plan, will generally be able to
redeem the rights at $0.001 per right at any time on or prior to a
triggering event. The rights will expire on February 19, 2011, unless
earlier redeemed by the Board of Directors.
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |                  
| | -----------------
| | 13.  INCOME TAXES



| |  |  | The Company accounts for income taxes under SFAS No. 109, Accounting for
Income Taxes. Deferred income tax assets and liabilities are determined
based upon differences between financial reporting and tax basis of
assets and liabilities and are measured using the enacted tax rates and
laws that will be in effect when the differences are expected to reverse.
| |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | A reconciliation of the difference between the effective income tax rate
and the statutory federal tax rate follows:                                                                                                                                                                                                                                                    

|                                    |  |      |         |      |  |   |         |  
|----------------------------------- |  | ---- | ------- | ---- |  | - | ------- | -
|                                    |  | 2001 |         | 2000
|                                    |  |      |         |     
|Tax at U.S. statutory rate          |  | $    | (51,145 | )    |  | $ | (30,813 | )
|State taxes, net of federal benefit |  |      | (2,698  | )    |  |   | (2,565  | )
|Goodwill amortization               |  |      | 19,725  |      |  |   | 768     |  
|Change in valuation allowance       |  |      | 36,779  |      |  |   | 32,218  |  
|Other                               |  |      | (2,661  | )    |  |   | 392     |  
|                                    |  |      |         |      |  |   |         |  
|                                    |  | $    |        |      |  | $ |        |  
|                                    |  |      |         |      |  |   |         |  



| |  |  | Significant components of the Company deferred tax assets are liabilities
are as follows:
| |  |  | -----------------------------------------------------------------------------------------

|                                     |                                  |   |          |        |      |   |         |        | 
|------------------------------------ | -------------------------------- | - | -------- | ------ | ---- | - | ------- | ------ | 
|                                     |                                  |   | 2001     |        | 2000
|                                     |                                  |   |          |        |     
|Current deferred tax assets:         |                                  |   |          |        |      |   |         |       
|                                     | Accounts receivable              |   | $        | 6,484  |      |   | $       | 3,430  | 
|                                     | Other                            |   |          | 127    |      |   |         | 214    | 
|Noncurrent deferred tax assets:      |                                  |   |          |        |      |   |         |       
|                                     | Net operating loss carrryforward |   |          | 98,817 |      |   |         | 65,358 | 
|                                     | Deferred compensation            |   |          | 538    |      |   |         | 468    | 
|                                     | Other                            |   |          | 674    |      |   |         | 505    | 
|                                     |                                  |   |          |        |      |   |         |       
|Gross deferred tax assets            |                                  |   | 106,640  |        |      |   | 69,975  |       
|Less: Valuation allowance            |                                  |   | (100,438 | )      |      |   | (63,659 | )     
|                                     |                                  |   |          |        |      |   |         |       
|                                     |                                  |   | 6,202    |        |      |   | 6,316   |       
|Noncurrent deferred tax liabilities: |                                  |   |          |        |      |   |         |       
|Property and equipment               |                                  |   | (3,943   | )      |      |   | (3,362  | )     
|Intangible assets                    |                                  |   | (2,259   | )      |      |   | (2,954  | )     
|                                     |                                  |   |          |        |      |   |         |       
|Net deferred tax asset               |                                  | $ |         |        |      | $ |        |       
|                                     |                                  |   |          |        |      |   |         |       

F-21



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | Generally accepted accounting principles require a valuation allowance to
reduce the deferred tax assets reported if, based on the weight of the
evidence, it is more likely than not that some portion or all of the
deferred tax assets will not be realized. After consideration of all of
the evidence, both positive and negative, management has determined that
a valuation allowance of approximately $100.4 and $63.6 million is
necessary at December 31, 2001 and 2000, respectively.
| |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | At December 31, 2001 and 2000, the Companys net operating loss
carryforward for federal income tax purposes is approximately $260.0 and
$172.0 million, respectively, expiring in various amounts from
2018
through 2021. The net operating loss carryforwards may be subject to
certain tax law provisions that limit
the utilization of net operating losses that were generated in
pre-acquisition years and any changes in ownership.                                                      



| |                                   
| | ----------------------------------
| | 14.  COMMITMENTS AND CONTINGENCIES



| |  |  | The Company has disputed billings and access charges to and from certain
inter-exchange carriers (IXCs) and incumbent local exchange carriers
(ILECs). The Company contends the invoicing and billings of access
charges are not in accordance with the interconnection, service level, or
tariff agreements entered between the Company and certain IXCs and ILECs.
The Company has not paid for a portion of these disputes and management
believes that the Company will prevail in these disputes. At December 31,
2001, the disputed amount not recorded in the financial statements was
approximately $5.6 million.                                             
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | In August 2000, the Company entered into an agreement with a service
firm to outsource customer provisioning through electronic bonding with
ILECs. The Company is committed to minimum cash
payments, subject to certain adjustments, of approximately $7.7
and $9.0 million for the years ended December 2003 and
2004, respectively.
The payments of these fees are subject to the successful completion by
the service firm of certain obligations in the future. This contract
provides for various termination arrangements with related severance
fees. During 2001 and 2000 we made payments under the agreement totaling
$6.3 and $0.5 million, respectively.



| |                                
| | -------------------------------
| | 15.  RELATED PARTY TRANSACTIONS



| |  |  | During 1998, various executives of the Company issued full recourse
promissory notes, totaling approximately $3.3 million to the Company in
connection with the purchase of 2,929,575 shares of common stock. These
notes are collateralized by the shares of common stock acquired with the
notes, and the Company holds those shares in escrow. The accompanying
consolidated financial statements include the notes as a decrease in
stockholders equity. The outstanding notes receivable related to these
notes at December 31, 2001 and 2000 are approximately $0.8 and $0.9
million, respectively. The Company received no payments in 2001 and
approximately $0.8 million in 2000. The principal balance of the notes
and the related accrued interest (8% per annum) were originally due
December 31, 2001, however, see Footnote 20  Subsequent Events, for
discussion of the extension of the outstanding notes until December 31,
2002. Interest income on these notes receivable was $0.1, $0.1 and 0.3
million for the years ended December 31, 2001, 2000 and 1999,
respectively.
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | In September 1999, the Company cancelled approximately $0.3 million of
notes receivable and reacquired 279,675 shares of common stock at $1.14
per share from an employee. These shares are presented as treasury
shares, at cost.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|
| |  |  | In May 2000, as a result of a change of control provision that was
triggered by the acquisition of Touch 1, Touch 1 purchased a building
used to house its technology infrastructure from its lessor, Brookwood,
L.L.C., for approximately $3.5 million from a limited liability company
of which an executive of Z-Tel is a significant shareholder.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

F-22



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | During 2000, the Company made total payments of approximately $5.6
million, exclusive of approximately $3.5 million to purchase a building
as described in the above paragraph, to an executive and several entities
affiliated with this executive pursuant to debt and lease agreements. The
entities and the various debt terms are outlined in Footnote 10 -
Long-Term Debt, under Related Party, with the total amounts owed to each
of the entities for each of the years ended December 31, 2001 and 2000.                                                                                                                                                                                                                                                         
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | During 2000, a member of the Board of Directors of the Company received
approximately $0.2 million and an option to purchase 12,500 shares of
common stock at $7.06 from Breckenridge Securities Corporation (BSC),
which fee was paid from amounts paid by the Company to BSC in connection
with services provided in conjunction with the issuances of Series D and
Series E Preferred. The member of the Board of Directors entered into
this agreement prior to being appointed to the Board.                                                                                                                                                                                                                                                                       
|
| |  |  | During 2000, the Company made payments of $0.1 million in rental payments
to Olympus Management Group, Inc., an entity 100% owned by a Company
executive.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|
| |  |  | In December 2000, the Company agreed to a guarantee of three employees
margin loans. Each employee executed an agreement with the Company in
which each pledges to the Company a security interest in all shares of
the Companys common stock they own as well as in all of their other
tangible and intangible property. In addition, each employee entered into
a Secured Promissory Note providing that, should the creditor who made
the margin loan to these employees draw any amounts on the Company
guarantee, such amounts would be considered advances under a secured
promissory note and would bear interest until paid. As of December 31,
2001 two of the three employees fulfilled their obligations leaving
approximately $1.1 million of the guarantee.
|
| |  |  | In January 2001, the Company accelerated the vesting of 50,000 stock
options granted to an executive as part of his severance agreement. This
acceleration resulted in the employee being fully vested in stock options
with a strike price of $3.64 when the stock was trading at $4.50. The
Company recorded approximately $0.1 million in general and administrative
expense as a result of this transaction.                                                                                                                                                                                                                                                                                                                                                          
|
| |  |  | In February 2001, the Company, made a loan to an employee in the amount
of 0.1 million. The interest rate of the note is 9.5% and it is payable
as a balloon payment on February 23, 2003. This note is collateralized
by any and all stock options, rights to salary and wages, and all
property personal, tangible, and intangible of the employee.                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| |  |  | In June 2001, the Company, as part of an executive severance agreement,
paid an executive approximately $0.3 million. This same executive
received an interest free loan of approximately $0.8 million, utilized to
exercise stock options to purchase 187,000 shares of common stock. This
note is collateralized by the shares of common stock acquired with the
note, and the Company holds those shares as security.                                                                                                                                                                                                                                                                                                                                                  
|
| |  |  | In August 2001, the Company cancelled approximately $0.7 million of notes
receivable and reacquired 61,875 shares of common stock at $1.14 per
share from the employee. These shares are presented as treasury shares,
at cost.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  |  | In September and October 2001, the Company loaned an employee an
aggregate of $0.1 million. The interest rate of the note is 6.5%
and is payable as a balloon payment on June 13, 2002. This note was for
relocation of the employee. There is no collateral pledge for this
note.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|



| |                           
| | --------------------------
| | 16.  EMPLOYEE BENEFIT PLAN



| |  |  | In 1999, the Company established a 401(k) plan covering defined employees
who meet established eligibility requirements. Under the original plan
provisions, the company did not make matching
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-23



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | contributions. Effective September 15, 2000, the Company merged the plans
of Touch 1 and Z-Tel and established a matching contribution for the
401(k) plan to 50% of participating contributions to a maximum matching
amount of 5% of a participants compensation. The Company contribution
was approximately $0.5 and $0.2 million for the years ended December 31,
2001 and 2000, respectively.
| |  |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |                              
| | -----------------------------
| | 17.  STOCK-BASED COMPENSATION



| |  |  | Effective October 30, 1998, the Company adopted the 1998 Equity
Participation Plan (1998 Plan), for the grant to eligible employees and
eligible participants of options to purchase up to 1,261,000 shares of
the Companys common stock. During September and November 1999, the Board
of Directors (the Board) increased the shares available for grant under
the 1998 Plan to 6.0 and 7.5 million shares, respectively.                                                                                                                              
| |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Effective April 20, 2000, the Company adopted the 2000 Equity
Participation Plan (2000 Plan), this plan allows for the grant to
eligible employees and eligible participants of options to purchase up to
2.0 million shares of the Companys common stock. The 2000 Plan
automatically increases the number of shares available for grant on the
first day of the companys fiscal year beginning in 2001 equal to the
lesser of (i) 3.0 million shares, (ii) 6% of the outstanding shares on
such date, or (iii) a lesser amount determined by the Board.
|
| |  |  | The Plan is administered by a committee appointed by the Board, or by the
Board. The Board or the appointed committee shall administer the 2000
Plan, select the eligible employees and eligible participants to whom
options will be granted, the price to be paid, the exercise period and
the number of shares subject to any such options and interpret, construe
and implement the provisions of the 2000 Plan.                                                                                                                                         
|
| |  |  | Stock option grants approximate the fair market value at the date of
grant. The vesting periods on these options range from immediately to
four years and have a maximum contractual life of ten years.                                                                                                                                                                                                                                                                                                                                                      
|
| |  |  | Prior to the adoption of the 1998 Plan, the Board awarded options (the
Initial Plan) for the right to purchase 3,868,800 shares of common
stock at a weighted average option price per share of $2.83. The vesting
periods on these options range from immediately to four years, and have a
maximum contractual life of ten years.                                                                                                                                                                                                                        
|
| |  |  | A summary of the stock option activity for the years ended December 31,
2001, 2000 and 1999 is presented below:                                                                                                                                                                                                                                                                                                                                                                                                                                              

|                               |           |  |              |          |                    |   |                    |      |          |  |             |           |             |   |           |       |          |  |           |           |   |   |       |       |          |  |            |            |   |   |      |       | 
|------------------------------ | --------- |  | ------------ | -------- | ------------------ | - | ------------------ | ---- | -------- |  | ----------- | --------- | ----------- | - | --------- | ----- | -------- |  | --------- | --------- | - | - | ----- | ----- | -------- |  | ---------- | ---------- | - | - | ---- | ----- | 
|                               |           |  |              |          |                    |   |                    |      |          |  | 1998 Equity |           | 2000 Equity |   |           |       |          |  |           |           |  
|                               |           |  | Initial Plan |          | Participation Plan |   | Participation Plan |      | Total   
|                               |           |  |              |          |                    |   |                    |      |         
|                               |           |  |              |          |                    |   | Weighted           |      |          |  |             |           | Weighted    |   |           |       |          |  | Weighted  |           |   |   |       |       | Weighted
|                               |           |  |              |          |                    |   | Average            |      |          |  |             |           | Average     |   |           |       |          |  | Average   |           |   |   |       |       | Average 
|                               |           |  | Number of    |          | Exercise           |   | Number of          |      | Exercise |  | Number of   |           | Exercise    |   | Number of |       | Exercise
|                               |           |  | Shares       |          | Price              |   | Shares             |      | Price    |  | Shares      |           | Price       |   | Shares    |       | Price   
|                               |           |  |              |          |                    |   |                    |      |          |  |             |           |             |   |           |       |         
|Outstanding,
December 31, 1998 |           |  | 3,799,300    |          |                    | $ | 2.83               |      |          |  | 201,050     |           |             | $ | 3.64      |       |          |  |          |           |   |   |      |       |          |  | 4,000,350  |            |   | $ | 2.88 |      
|                               | Granted   |  |              |         |                    |   |                    |     |          |  |             | 3,181,225 |             |   |           | 5.78  |          |  |           |          |   |   |       |      |          |  |            | 3,181,225  |   |   |      | 5.78  | 
|                               | Exercised |  |              | (305,094 | )                  |   |                    | 1.73 |          |  |             | (1,466    | )           |   |           | 3.64  |          |  |           |          |   |   |       |      |          |  |            | (306,560   | ) |   |      | 1.74  | 
|                               | Forfeited |  |              | (155,873 | )                  |   |                    | 3.36 |          |  |             | (202,945  | )           |   |           | 3.65  |          |  |           |          |   |   |       |      |          |  |            | (358,818   | ) |   |      | 3.53  | 
|                               |           |  |              |          |                    |   |                    |      |          |  |             |           |             |   |           |       |          |  |           |           |   |   |       |       |          |  |            |            |   |   |      |      
|Outstanding,
December 31, 1999 |           |  | 3,338,333    |          |                    |   | 2.91               |      |          |  | 3,177,864   |           |             |   | 5.79      |       |          |  |          |           |   |   |      |       |          |  | 6,516,197  |            |   |   | 4.31 |      
|                               | Granted   |  |              |         |                    |   |                    |     |          |  |             | 1,415,100 |             |   |           | 27.29 |          |  |           | 1,897,440 |   |   |       | 11.52 |          |  |            | 3,312,540  |   |   |      | 18.26 | 
|                               | Exercised |  |              | (415,450 | )                  |   |                    | 2.47 |          |  |             | (435,545  | )           |   |           | 4.15  |          |  |           |          |   |   |       |      |          |  |            | (850,995   | ) |   |      | 3.33  | 
|                               | Forfeited |  |              | (34,631  | )                  |   |                    | 2.67 |          |  |             | (530,231  | )           |   |           | 14.71 |          |  |           | (145,800  | ) |   |       | 12.34 |          |  |            | (710,662   | ) |   |      | 13.64 | 
|                               |           |  |              |          |                    |   |                    |      |          |  |             |           |             |   |           |       |          |  |           |           |   |   |       |       |          |  |            |            |   |   |      |      
|Outstanding,
December 31, 2000 |           |  | 2,888,252    |          |                    |   | 2.98               |      |          |  | 3,627,188   |           |             |   | 13.07     |       |          |  | 1,751,640 |           |   |   | 11.45 |       |          |  | 8,267,080  |            |   |   | 9.20 |      
|                               | Granted   |  |              |         |                    |   |                    |     |          |  |             |          |             |   |           |      |          |  |           | 4,257,450 |   |   |       | 1.69  |          |  |            | 4,257,450  |   |   |      | 1.69  | 
|                               | Exercised |  |              | (47,486  | )                  |   |                    | 2.32 |          |  |             | (130,253  | )           |   |           | 3.64  |          |  |           |          |   |   |       |      |          |  |            | (177,739   | ) |   |      | 3.29  | 
|                               | Forfeited |  |              | (97,144  | )                  |   |                    | 2.49 |          |  |             | (638,227  | )           |   |           | 12.70 |          |  |           | (727,376  | ) |   |       | 9.84  |          |  |            | (1,462,747 | ) |   |      | 10.60 | 
|                               |           |  |              |          |                    |   |                    |      |          |  |             |           |             |   |           |       |          |  |           |           |   |   |       |       |          |  |            |            |   |   |      |      
|Outstanding,
December 31, 2001 |           |  | 2,743,622    |          |                    | $ | 3.01               |      |          |  | 2,858,708   |           |             | $ | 13.58     |       |          |  | 5,281,714 |           |   | $ | 3.81  |       |          |  | 10,884,044 |            |   | $ | 6.17 |      
|                               |           |  |              |          |                    |   |                    |      |          |  |             |           |             |   |           |       |          |  |           |           |   |   |       |       |          |  |            |            |   |   |      |      

F-24



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | Had compensation cost for the Companys stock options granted been
determined based on the fair value at the date of grant, consistent with
the provisions of SFAS No. 123, the Companys net loss and loss per share
of common stock for the years ended December 31, 2001, 2000 and 1999,
respectively, would have
been increased to the pro forma amounts shown below.
| |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                            |              |  |              |          |      |  |      |         |   |  |   |         |  
|------------------------------------------- | ------------ |  | ------------ | -------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                            |              |  | Year Ended  
|                                            |              |  | December 31,
|                                            |              |  |             
|                                            |              |  | 2001         |          | 2000 |  | 1999
|                                            |              |  |              |          |      |  |     
|Net Loss                                    |              |  |              |          |      |  |      |         |   |  |   |        
|                                            | As presented |  | $            | (146,068 | )    |  | $    | (88,037 | ) |  | $ | (35,971 | )
|                                            | As adjusted  |  |              | (158,929 | )    |  |      | (99,174 | ) |  |   | (36,477 | )
|Basic
and Diluted Net Loss per Common Share |              |  |              |          |      |  |      |         |   |  |   |        
|                                            | As presented |  | $            | (5.03    | )    |  | $    | (3.38   | ) |  | $ | (2.49   | )
|                                            | As adjusted  |  |              | (5.41    | )    |  |      | (3.72   | ) |  |   | (2.53   | )



| |  |  | These adjusted amounts were determined using the Black-Scholes valuation
model with the following key assumptions: (a) a discount rate of
approximately 4.7%, 6.5%, and 5.7% for each of the years ended December
31, 2001, 2000, 1999, (b) a volatility factor of approximately 87%, 123%
and 81% for each of the years ending December 31, 2001, 2000 and 1999,
respectively; (c) an average expected option life of 5 years; (d) there
have been no options that have expired; and (e) no payment of dividends
on common stock.
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | During 2001, 2000 and 1999, respectively, included in the options granted
by the Company, are 0, 0, and 695,082 options granted to non-employees.
The Company recorded expense for the same periods, respectively, of
approximately $0.0, $0.0, and $0.3 million, respectively, related to
these non-employee options in accordance with the provisions of SFAS No.
123.                                                                                                                                                          
|
| |  |  | The following table summarizes information about stock options outstanding
at December 31, 2001:                                                                                                                                                                                                                                                                                                                                                                                                                                  

|                |               |             |            |            |                  |             |           |     |  |  |           |           | 
|--------------- | ------------- | ----------- | ---------- | ---------- | ---------------- | ----------- | --------- | --- |  |  | --------- | --------- | 
|                |               |             |            |            |                  |             | Remaining |     |  |  |          
|                |               |             | Number     |            | Contractual Life |             | Number   
|Exercise Prices |               | Outstanding |            | (In Years) |                  | Exercisable
|                |               |             |            |            |                  |            
|                | $0.82 - $4.00 |             |            | 7,463,322  |                  |             |           | 8.2 |  |  |           | 3,386,110 | 
|                | 5.45 - 10.00  |             |            | 1,322,607  |                  |             |           | 8.2 |  |  |           | 788,651   | 
|                | 12.00 - 19.00 |             |            | 1,561,015  |                  |             |           | 8.4 |  |  |           | 835,061   | 
|                | 23.00 - 47.00 |             |            | 537,100    |                  |             |           | 8.3 |  |  |           | 302,913   | 
|                |               |             |            |            |                  |             |           |     |  |  |           |          
|                |               |             | 10,884,044 |            |                  |             |           |     |  |  | 5,312,735 |          
|                |               |             |            |            |                  |             |           |     |  |  |           |          



| |                                       
| | --------------------------------------
| | 18.  COMPUTATION OF NET LOSS PER SHARE



| |  |  | Basic net loss per share is computed by dividing net loss attributable to
common stockholders by the weighted average number of common shares
outstanding during the period. Incremental shares of common stock
equivalents are not included in the calculation of net loss per share as
the inclusion of such equivalents would be anti-dilutive.
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-25



---



##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | Net loss per share is calculated as follows:
| |  |  | --------------------------------------------

|                                      |                                            |                                                                                 |                                              |            |              |          |      |            |         |          |   |            |         |         |  
|------------------------------------- | ------------------------------------------ | ------------------------------------------------------------------------------- | -------------------------------------------- | ---------- | ------------ | -------- | ---- | ---------- | ------- | -------- | - | ---------- | ------- | ------- | -
|                                      |                                            |                                                                                 |                                              |            | Year Ended   |         
|                                      |                                            |                                                                                 |                                              |            | December 31, |         
|                                      |                                            |                                                                                 |                                              |            |              |         
|                                      |                                            |                                                                                 |                                              |            | 2001         |          | 2000 |            | 1999   
|                                      |                                            |                                                                                 |                                              |            |              |          |      |            |        
|Basic
and diluted net loss per share: |                                            |                                                                                 |                                              |            |              |          |      |            |         |          |   |           
|                                      | Loss attributable to common stockholders:  |                                                                                 |                                              |            |              |          |      |            |         |          |   |            |        
|                                      |                                            | Net loss                                                                        |                                              | $          | (146,068     | )        |      | $          | (88,037 | )        |   | $          | (35,971 | )      
|                                      |                                            | Less mandatorily redeemable convertible preferred
stock dividends and accretion |                                              |            | (15,059      | )        |      |            | (3,644  | )        |   |            | (1,654  | )      
|                                      |                                            | Less deemed dividend related to beneficial conversion feature                   |                                              |            | (9,356       | )        |      |            | (20,027 | )        |   |            |        |        
|                                      |                                            |                                                                                 |                                              |            |              |          |      |            |         |          |   |           
|                                      |                                            |                                                                                 | Net
loss attributable to common stockholders |            | $            | (170,483 | )    |            | $       | (111,708 | ) |            | $       | (37,625 | )
|                                      |                                            |                                                                                 |                                              |            |              |          |      |            |         |          |   |           
|                                      | Weighted average common shares outstanding |                                                                                 |                                              | 33,908,374 |              |          |      | 33,066,538 |         |          |   | 15,099,359 |        
|                                      |                                            |                                                                                 |                                              |            |              |          |      |            |         |          |   |           
|                                      | Basic and diluted net loss per share       |                                                                                 | $                                            | (5.03      | )            |          | $    | (3.38      | )       |          | $ | (2.49      | )      
|                                      |                                            |                                                                                 |                                              |            |              |          |      |            |         |          |   |           



| |  |  | For each of the periods presented, basic and diluted net loss per share
are the same. Unexercised options to purchase 10,884,044, 8,267,080 and
6,516,197 shares of common stock, unexercised warrants to purchase
10,425,982, 4,602,457, and 637,332 shares of common stock, mandatorily
redeemable convertible preferred stock convertible into 25,941,481,
9,174,605 and 0 shares of common stock for the years ended December 31,
2001, 2000 and 1999, respectively, which could potentially dilute basic
earnings per share in the future. These potentially dilutive items were
not included in the computation of diluted net loss per share for these
periods because to do so would have been anti-dilutive in each case.
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |                                      
| | -------------------------------------
| | 19.  LEGAL AND REGULATORY PROCEEDINGS



| |  |  | On June 9, 2000, PTEK Holdings, Inc. and Premiere Communications, Inc.
(collectively, PTEK) filed a lawsuit against the Company, Z-Tel
Communications, Inc., David Gregory Smith, Z-Tels Chairman, Chief
Executive Officer and President, Eduard Mayer, one of Z-Tels directors
and James Kitchen, a Senior Vice President of Z-Tel (the Lawsuit).                                                                                                                                                                                                                                                                                                                                                  
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | On November 14, 2000, the parties to the Lawsuit agreed to resolve in
full all claims asserted by each party against the other. In connection
with the settlement, the Company agreed to issue a warrant to PTEK
Holdings, Inc. to purchase 175,000 shares of the Companys common stock
at an exercise price of $12.00, which price is subject to certain
adjustments. The warrant is fully vested and non-forfeitable but is not
exercisable until two years after the issue date of the warrant. As a
result of the issuance of the warrant and the accrual of legal fees
related to the Lawsuit, the Company recognized an expense of
approximately $1.0 million for the year ended December 31, 2000.
|
| |  |  | On March 15, 2001, Z-Tel filed suit against AT&T. In that suit, Z-Tel
alleged that AT&T had received originating and terminating access service
from Z-Tel and has unlawfully withheld access charges for such services
from Z-Tel. In July 2001, AT&T and the Company agreed to a settlement. In
connection with that settlement, which approximated the amounts recorded
by the Company as receivables, the Company resolved the issues relating
to charges for access services rendered. The Company entered into a
switched access agreement setting forth terms and conditions under which
AT&T will purchase access services from the Company in the future.                                        

F-26



---



##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |  |  | During June and July 2001, three separate class action lawsuits were
filed against the Company, certain of the Companys current and former
directors and officers (the D&Os) and firms engaged in the underwriting
(the Underwriters) of our initial public offering of stock (the IPO).
Each of the lawsuits is based on the allegations that the Companys
registration statement on Form S-1, filed with the Securities and
Exchange Commission (SEC) in connection with the IPO, contained untrue
statements of material fact and omitted to state facts necessary to make
the statements made not misleading by failing to disclose that the
underwriters had received additional, excessive and undisclosed
commissions from, and had entered into unlawful tie-in and other
arrangements with, certain customers to whom they allocated shares in the
IPO. Plaintiffs have asserted claims against the Company and the D&Os
pursuant to Sections 11 and 15 of the Securities Act of 1933 and Sections
10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated by the SEC thereunder. The plaintiffs seek an undisclosed
amount of damages, as well as pre-judgment and post-judgment interest,
costs and expenses, including attorneys fees, experts fees and other
costs and disbursements. The lawsuits, along with all other lawsuits
filed against other issuers arising out of IPO allocations, have been
assigned to Judge Shira A. Scheindlin for pretrial coordination. The
complaints have been consolidated into a single action, Case
No. 01-5074. A consolidated complaint had not been filed or designated, and
the Company is not required to file an answer or other responsive
pleadings at this time.
| |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | In the ordinary course of business, the Company is involved in legal
proceedings that are generally incidental to its operations. In addition,
from time to time, the Company is the subject of customer complaints
filed with the state utility commissions of the states in which it
operates or the FCC. Most complaints are handled informally and at this
time there are no formal proceedings pending. While there can be no
assurance of the ultimate disposition of incidental legal proceedings or
customer complaints, the Company does not believe their disposition will
have a material adverse effect on the Companys consolidated results of
operations or financial position.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    



| |                       
| | ----------------------
| | 20.  SUBSEQUENT EVENTS



| |  |  | On January 28, 2002, the
Company approved the extension of time to re-pay loans due December
31, 2001 until December 31, 2002. The loans are payable from three
employees in the amounts of $0.5, $0.3, and $0.1 million and will
continue to accrue interest at 8% annually. These notes are
collateralized by the shares of common stock acquired with the notes
and the Company holds these shares in escrow.
| |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On March 20, 2002, the
Company entered into a four-year contract with MCI WORLDCOM
Communications, Inc. (MCI) whereby we expect to provide to MCI local
exchange services, Z-Line Features, operational and support services and
licenses to use certain of our proprietary technology, all for MCIs use
in providing telecommunications services to residential and small business
customers. The contract provides, among other things, that certain of
our services will be provided at direct cost; we will receive technology
licensing fees and fees for usage of our Z-Line platform, which provides
the Z-Line Features; MCI will share with us gross profits it earns in
providing certain Z-Line Features to its customers; MCI will
purchase
one million of our common shares; and Z-Tel will pay a cash signing
bonus of $2.3 million. The contract caps total software
licensing fees at $50 million, but until that cap is reached, monthly
software licensing fees together with certain monthly per line fees for the
use of our technology are not to be less than $1.5 million,
reduced by any prepayments made prior to the agreement. We expect to
begin providing these services on a test basis in April 2002.
| |  |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F-27



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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tables are in thousands, except for share and per share data)



| |                                                         
| | --------------------------------------------------------
| | SUPPLEMENTAL QUARTERLY FINANCIAL INFORMATION (UNAUDITED)



| |  |  | In the following summary of quarterly financial information, all
adjustments necessary for a fair presentation of each period were
included.
| |  |  | --------------------------------------------------------------------------------------------------------------------------------------------

|                                    |  |               |            |          |  |               |            |              |  |   |            |   |  |   |            |  
|----------------------------------- |  | ------------- | ---------- | -------- |  | ------------- | ---------- | ------------ |  | - | ---------- | - |  | - | ---------- | -
|                                    |  | Quarter Ended
|                                    |  |              
|                                    |  | March 31,     |            | June 30, |  | September 30, |            | December 31,
|                                    |  | 2000          |            | 2000     |  | 2000          |            | 2000        
|                                    |  |               |            |          |  |               |            |             
|Sales                               |  | $             | 13,976     |          |  | $             | 40,157     |              |  | $ | 54,415     |   |  | $ | 69,120     |  
|Operating loss                      |  |               | (16,521    | )        |  |               | (22,687    | )            |  |   | (22,228    | ) |  |   | (29,763    | )
|Net loss                            |  |               | (15,476    | )        |  |               | (23,055    | )            |  |   | (23,109    | ) |  |   | (26,397    | )
|Loss per share (1)                  |  | $             | (0.48      | )        |  | $             | (0.71      | )            |  | $ | (0.96      | ) |  | $ | (1.23      | )
|Weighted average shares
outstanding |  |               | 31,941,964 |          |  |               | 33,042,008 |              |  |   | 33,536,724 |   |  |   | 33,717,824 |  

|                                    |  |               |            |          |  |               |            |              |  |  |   |            |   |  |   |           
|----------------------------------- |  | ------------- | ---------- | -------- |  | ------------- | ---------- | ------------ |  |  | - | ---------- | - |  | - | ----------
|                                    |  | Quarter Ended
|                                    |  |              
|                                    |  | March 31,     |            | June 30, |  | September 30, |            | December 31,
|                                    |  | 2001          |            | 2001     |  | 2001          |            | 2001        
|                                    |  |               |            |          |  |               |            |             
|Sales                               |  | $             | 75,044     |          |  | $             | 73,142     |              |  |  | $ | 68,569     |   |  | $ | 59,142    
|Operating loss                      |  |               | (19,630    | )        |  |               | (107,878   | )            |  |  |   | (12,213    | ) |  |   | (9,420    
|Net
loss (2)(3)                     |  |               | (17,580    | )        |  |               | (107,743   | )            |  |  |   | (11,855    | ) |  |   | (8,890    
|Loss per share (1)                  |  | $             | (0.60      | )        |  | $             | (3.27      | )            |  |  | $ | (0.77      | ) |  | $ | (0.40     
|Weighted average shares
outstanding |  |               | 33,790,809 |          |  |               | 33,880,327 |              |  |  |   | 33,982,665 |   |  |   | 33,977,666



---

|(1) |  | Earnings per share were calculated for each three month
period on a stand-alone basis.                                              
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | We recorded a $59.2 million expense related to impaired
assets in second quarter 2001.                                              
|   
|(3) |  | We recorded a write-off of accounts receivable that resulted
in $29.9 million of additional bad debt expense in second quarter 2001.

F-28



---



##### Table of Contents



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

None.

PART III

Item 10.Directors and Executive Officers of the Registrant

Directors and Executive Officers

Information regarding directors, nominees for director and executive
officers is in our 2002 Annual Meeting proxy statement and is incorporated
herein by reference.

Item 11. Executive Compensation

Information regarding executive compensation is included in the our 2002
Annual Meeting proxy statement and is incorporated herein by reference.

Item 12.Security Ownership of Certain Beneficial Owners and Management

Information required by this item is included in our 2002 Annual Meeting
proxy statement and is incorporated herein by reference.

Item 13.Certain Relationships and Related Transactions

Information required by this item is included in our 2002 Annual Meeting
proxy statement and is incorporated herein by reference.

PART IV

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



|(a) | 1. |  | The following financial statements of Z-Tel Technologies, Inc. and the
report thereon of PricewaterhouseCoopers LLP dated February 22,
2002, except Note 20, as to which the date is March 20, 2001 are
filed as part of this report:
|--- | -- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|    |    |  | Report of Independent Certified Public Accountants.                                                                                                                                                                                  
|   
|    |    |  | Consolidated Balance Sheets, December 31, 2001 and December 31, 2000                                                                                                                                                                 
|   
|    |    |  | Consolidated Statements of Operations for the years ended December 31,
2001, 2000, 1999.                                                                                                                                             
|   
|    |    |  | Consolidated Statements of Changes in Stockholders Equity (Deficit) for
the years ended December 31, 2001, 2000, and 1999.                                                                                                          
|   
|    |    |  | Consolidated Statements of Cash Flows for the years ended December 31,
2001, 2000 and 1999.                                                                                                                                          
|   
|    |    |  | Notes to Financial Statements.                                                                                                                                                                                                       
|   
|(a) | 2. |  | The following Financial Statement Schedules are included herein:                                                                                                                                                                     
|   
|    |    |  | Schedules are not submitted because they are not applicable or not
required or because the required information is included in the financial
statements or the notes thereto.                                                        

46



---



##### Table of Contents





| | (a) 3. |  | The following exhibits are filed as part of this report (exhibits marked
with an asterisk have been previously filed with the Commission as
indicated, and are incorporated herein by this reference):
| | ------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|        |  |                                                                                                                                                                                                                                                                                                                                            
|------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT |  |                                                                                                                                                                                                                                                                                                                                            
|NUMBER  |  | DESCRIPTION                                                                                                                                                                                                                                                                                                                                
|        |  |                                                                                                                                                                                                                                                                                                                                            
|2.1     |  | Stock and Asset Purchase Agreement, dated June 30, 2001, by and among
direcTEL Inc., a New Brunswick, Canada corporation, direcTEL, Inc., an Alabama
corporation, Touch 1 Communications, Inc., an Alabama corporation, Z-Tel Technologies,
Inc., a Delaware corporation and WebSmart Teleservices Group, Inc., a North Dakota
corporation.
|       
|       
|       
|       
|3.1     |  | Amended and Restated Certificate of Incorporation of Z-Tel, as
amended(A)*                                                                                                                                                                                                                                                                 
|       
|       
|       
|       
|3.2     |  | Amended and Restated Bylaws of Z-Tel(B)*                                                                                                                                                                                                                                                                                                   
|       
|       
|       
|       
|4.1     |  | Form of Common Stock Certificate(B)*                                                                                                                                                                                                                                                                                                       
|       
|       
|       
|       
|4.2     |  | See Exhibits 3.1 and 3.2 of this Form 10-K for provisions of the
Amended and Restated Certificate of Incorporation, as amended, and the Bylaws of Z-Tel defining
rights of security holders                                                                                                                                                
|       
|       
|       
|       
|4.3     |  | Stock Purchase Agreement, dated July 6, 2000, by and between the
Registrant and the various purchasers of the Registrants Series D Convertible Preferred
Stock(C)*                                                                                                                                                                        
|       
|       
|       
|       
|4.4     |  | Certificate of Designations, Preferences and Relative Rights,
Qualifications, Limitations and Restrictions relating to the Registrants Series D
Convertible Preferred Stock(C)*                                                                                                                                                           
|       
|       
|       
|       
|4.5     |  | Form of Registration Rights Agreement by and between the Registrant
and each of the purchasers of the Registrants Series D Convertible Preferred Stock(C)*                                                                                                                                                                                
|       
|       
|       
|       
|4.6     |  | Form of Warrant for the purchase of shares of common stock of the
Registrant by each of the purchasers of the Registrants Series D Convertible Preferred
Stock(C)*                                                                                                                                                                        
|       
|       
|       
|       
|4.7     |  | Stock and Warrant Purchase Agreement, dated October 19, 2000, by
and among the Registrant and The 1818 Fund III, L.P.(D)*                                                                                                                                                                                                                  
|       
|       
|       
|       
|4.8     |  | Certificate of Designation of 8% Convertible Preferred Stock,
Series E, Setting Forth the Powers, Preferences, Rights, Qualifications, Limitations and
Restrictions of Such Series of Preferred Stock, as amended(A)*                                                                                                                      
|       
|       
|       
|       
|4.9     |  | Registration Rights Agreement between and among the Registrant
and The 1818 Fund III, L.P.(D)*                                                                                                                                                                                                                                             
|       
|       
|       
|       
|4.10    |  | Warrant for the purchase of shares of common stock of the
Registrant by The 1818 Fund III, L.P.(D)*                                                                                                                                                                                                                                        
|       
|       
|       
|       
|4.11    |  | Certificate of Designation of Series F Junior Participating
Preferred Stock(E)*                                                                                                                                                                                                                                                            
|       
|       
|       
|       
|4.12    |  | Rights Agreement dated as of February 19, 2001 between Z-Tel
Technologies, Inc. and American Stock Transfer Trust Company, as Rights Agent, as amended July 2,
2001(E)*                                                                                                                                                                    
|       
|       
|       
|       
|4.13    |  | Stock and Warrant Purchase Agreement, dated as of July 2, 2001,
by and between Z-Tel, D. Gregory Smith, and others(G)                                                                                                                                                                                                                      
|       
|       
|       
|       
|4.14    |  | Warrant for the Purchase of Shares of Common Stock of Z-Tel, dated as of
July 2, 2001(H)*                                                                                                                                                                                                                                                  
|       
|       
|       
|       
|4.15    |  | Certificate of Designation for the Series G Preferred Stock(I)*                                                                                                                                                                                                                                                                            
|       
|       
|       
|       
|4.16    |  | Backup Purchase Agreement, dated as of July 2, 2001, by and among
Z-Tel Communications, Inc., a Delaware corporation and a wholly owned subsidiary of
Z-Tel, Touch 1 Communications, Inc., an Alabama corporation and a wholly owned
subsidiary of Z-Tel, D. Gregory Smith and others(J)*                                                  
|       
|       
|       
|       
|4.17    |  | Additional Investor Registration Rights Agreement, dated as of July 2,
2001, between Z-Tel, D. Gregory Smith and others(K)*                                                                                                                                                                                                                
|       
|       
|       
|       
|4.18    |  | Voting Agreement, dated as of June 29, 2001, between Z-Tel and certain
stockholders of Z-Tel(L)*                                                                                                                                                                                                                                           
|       
|       
|       
|       
|4.19    |  | Employee Stock Restriction Agreement, dated September 1, 1999, by and
between the Company and D. Gregory Smith(M)*                                                                                                                                                                                                                         

47



---



##### Table of Contents



|        |  |                                                                                                                                                                                                                                   
|------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT |  |                                                                                                                                                                                                                                   
|NUMBER  |  | DESCRIPTION                                                                                                                                                                                                                       
|        |  |                                                                                                                                                                                                                                   
|       
|       
|       
|       
|10.1.1  |  | Stockholders Agreement dated October 8, 1999, between and among the
Company, BA Capital Corporation, Sewanee Partners II, L.P., Gramercy Z-Tel LLC and the other
parties set forth therein(B)*                                   
|       
|       
|       
|       
|10.1.2  |  | Employment Agreement dated July 1998 between the Company and D.
Gregory Smith, as amended April 4, 2001 to increase his annual salary to $275,000(B)*                                                                             
|       
|       
|       
|       
|10.1.4  |  | Employment Agreement dated August 1998 between the Company and Charles
W. McDonough as amended April 4, 2001 to increase his annual salary to $240,000(B)*                                                                        
|       
|       
|       
|       
|10.1.5  |  | Employment Agreement dated August 1998 between the Company and J.
Bryan Bunting as amended April 4, 2001 to increase his annual salary to $200,000(B)*                                                                            
|       
|       
|       
|       
|10.1.6  |  | Employment Agreement dated July 1998 between the Company and
James A. Kitchen as amended April 4, 2001 to increase his annual salary to $175,000(B)*                                                                              
|       
|       
|       
|       
|10.1.7  |  | Investment Agreement dated March 15, 1999 between the Company and
CMB Capital LLC(B)*                                                                                                                                             
|       
|       
|       
|       
|10.2.1  |  | 1998 Equity Participation Plan(B)*                                                                                                                                                                                                
|       
|       
|       
|       
|10.2.2  |  | 2000 Equity Participation Plan(N)*                                                                                                                                                                                                
|       
|       
|       
|       
|10.4    |  | Receivables Sales Agreement dated as of July 27, 2000 by and
between Z-Tel Communications, Inc., as seller and subservicer, Touch 1 Communications,
Inc., as seller and subservicer, and RFC Capital Corporation, as purchaser(C)*
|       
|       
|       
|       
|10.5    |  | Form of Indemnification Agreement for executive officers and
directors of the Company(E)*                                                                                                                                         
|       
|       
|       
|       
|10.6    |  | Loan and Guaranty Agreement dated January 11, 2001 between the
Company and James A. Kitchen(E)*                                                                                                                                   
|       
|       
|       
|       
|10.7    |  | Secured Promissory Note dated January 11, 2001 delivered by James
A. Kitchen to the Company(E)*                                                                                                                                   
|       
|       
|       
|       
|10.8    |  | Pledge and Security Agreement dated January 11, 2001 between
James A. Kitchen and theCompany(E)*                                                                                                                                  
|       
|       
|       
|       
|10.10   |  | Promissory Note, dated May 11, 1999, between Touch 1 Communications,
Inc. and Corman Elegre Capital(D)*                                                                                                                           
|       
|       
|       
|       
|10.11   |  | Promissory Note, dated September 10, 1999, from Touch 1
Communications, Inc. and William F. Corman (First Revocable Trust)(D)*                                                                                                    
|       
|       
|       
|       
|10.12   |  | Promissory Note, dated September 10, 1999, from Touch 1
Communications, Inc. and
James F. Corman(D)*                                                                                                                              
|       
|       
|       
|       
|21.     |  | List of Subsidiaries                                                                                                                                                                                                              
|       
|       
|       
|       
|23.     |  | Consent of PricewaterhouseCoopers LLP                                                                                                                                                                                             




|    |  |                                                                                                                                                                                            
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*   |  |                                                                                                                                                                                            
|   
|   
|   
|   
|(A) |  | Incorporated by reference to the correspondingly numbered exhibit to
the Registrants Quarterly Report on Form 10-Q for the quarterly period ended June 30,
2001, filed on August 13, 2001.

48



---



##### Table of Contents



|    |  |                                                                                                                                                                                                                                 
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|   
|   
|   
|(B) |  | Incorporated by reference to the correspondingly numbered exhibit
to the Registrants Registration Statement on Form S-1 (File No. 333-89063), originally filed
October 14, 1999, as amended and as effective December 14, 1999.
|   
|   
|   
|   
|(C) |  | Incorporated by reference to the correspondingly numbered exhibits to the Registrants
Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2000, filed on
August 14, 2000.                                    
|   
|   
|   
|   
|(D) |  | Incorporated by reference to the correspondingly numbered exhibits to the Registrants
Quarterly Report on Form 10-Q for the quarterly period ended September 30,
2000, filed on November 14, 2000.                             
|   
|   
|   
|   
|(E) |  | Incorporated by reference to the correspondingly numbered exhibits to the Registrants
Annual Report on Form 10-K for the annual period ended December 31, 2000,
filed on March 30, 2001.                                       
|   
|   
|   
|   
|(F) |  | Incorporated by reference to the correspondingly numbered exhibits to the Registrants
Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2001, filed on
August 13, 2001.                                    
|   
|   
|   
|   
|(G) |  | Incorporated by reference to Exhibit 1 to Amendment No. 1 of the Schedule 13D filed
July 12, 2001 with respect to Z-Tels common stock by, among other
persons, The 1818 Fund III, L.P.                                         
|   
|   
|   
|   
|(H) |  | Incorporated by reference to Exhibit 2 to Amendment No. 1 of the Schedule
13D filed July 12, 2001 with respect to Z-Tels common stock by, among
other persons, The 1818 Fund III, L.P.                                         
|   
|   
|   
|   
|(I) |  | Incorporated by reference to Exhibit 3 to Amendment No. 1 of the Schedule
13D filed July 12, 2001 with respect to Z-Tels common stock by, among
other persons, The 1818 Fund III, L.P.                                         
|   
|   
|   
|   
|(J) |  | Incorporated by reference to Exhibit 4 to Amendment No. 1 of the Schedule
13D filed July 12, 2001 with respect to Z-Tels common stock by,
among other persons, The 1818 Fund III, L.P.                                         
|   
|   
|   
|   
|(K) |  | Incorporated by reference to Exhibit 5 to the Schedule 13D filed July 24,
2001 with respect to Z-Tels common stock by, among other persons, D. Gregory Smith.                                                                  
|   
|   
|   
|   
|(L) |  | Incorporated by reference to Exhibit 5 to Amendment No. 1 of the Schedule
13D filed July 12, 2001 with respect to Z-Tels common stock by, among
other persons, The 1818 Fund III, L.P.                                         
|   
|   
|   
|   
|(M) |  | Incorporated by reference to Exhibit 7 to the Schedule 13D filed July 24,
2001 with respect to Z-Tels common stock by, among other persons, D.
Gregory Smith.                                                                  
|   
|   
|   
|   
|(N) |  | Incorporated by reference to Appendix B to the Registrants Preliminary Proxy Statement
filed on April 14, 2000, with the following amendment effective May 31,
2001:                                                           

| |  |                                                                                 
| |  | --------------------------------------------------------------------------------
| |  | Section 2.1(a) of the Plan is hereby amended in its entirety
to read as follows:

| |  |     |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |  | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | (a) |  | The shares of stock subject to Options,
awards of Restricted Stock, Performance Awards, Dividend
Equivalents, awards of Deferred Stock, Stock Payments or Stock
Appreciation Rights shall be Common Stock, initially shares of
the Companys Common Stock, par value $0.01 per share. The
aggregate number of such shares which may be issued upon
exercise of such options or rights or upon any such awards
under the Plan shall be Four Million Five Hundred Thousand
(4,500,000) plus an annual increase to be added on the first
day of the Companys fiscal year beginning in 2001 equal to
the lesser of (i) Three Million (3,000,000) shares of the
Companys Common Stock, (ii) 6% of the outstanding shares on
such date, or (iii) a lesser amount determined by the Board.
The shares of Common Stock issuable upon exercise of such
options or rights or upon any such awards may be either
previously authorized but unissued shares or treasury shares.




| | (b) |  | Reports on
Form 8-K.
None.
| | --- |  | --------------------------

49



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed
on its behalf by the undersigned, thereunto duly authorized, as of the [26]th
day of March, 2002.

| |  |                                                                                
| |  | -------------------------------------------------------------------------------
| |  | Z-TEL TECHNOLOGIES, INC.                                                       
|
| |  | By: /s/ D. Gregory SmithD. Gregory Smith, President
and Chief Executive Officer

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

|                                            |  |                                                                                              |  |               
|------------------------------------------- |  | -------------------------------------------------------------------------------------------- |  | --------------
|Signature                                   |  | Title                                                                                        |  | Date          
|                                           
|/s/ D. Gregory SmithD. Gregory Smith        |  | President, CEO, Chairman
of the Board and Director
(Principal Executive Officer)             |  | March 26, 2002
|                                           
|                                            |  |                                                                                              |  |               
|                                           
|/s/ Horace J.  Davis IIIHorace J. Davis III |  | Senior Vice President 
Chief Financial Officer
(Principal Financial and
Accounting Officer) |  | March 26, 2002
|                                           
|                                            |  |                                                                                              |  |               
|                                           
|/s/Charles W. McDonoughCharles W. McDonough |  | Senior Vice President 
Chief Technology Officer, and Director                               |  | March 26, 2002
|                                           
|                                            |  |                                                                                              |  |               
|                                           
|/s/ Jeffrey A. BowdenJeffrey A. Bowden      |  | Director                                                                                     |  | March 25, 2002
|                                           
|                                            |  |                                                                                              |  |               
|                                           
|/s/ Charles D. HymanCharles D. Hyman        |  | Director                                                                                     |  | March 26, 2002
|                                           
|                                            |  |                                                                                              |  |               
|                                           
|/s/ Andrew C. CowenAndrew C. Cowen          |  | Director                                                                                     |  | March 29, 2002
|                                           
|                                            |  |                                                                                              |  |               
|                                           
|/s/ John K. AurrelJohn K. Aurrell           |  | Director                                                                                     |  | March 26, 2002
|                                           
|                                            |  |                                                                                              |  |               
|                                           
|/s/ Mark S. FeighnerMark S. Feighner        |  | Director                                                                                     |  | March 26, 2002
|                                           
|                                            |  |                                                                                              |  |               
|                                           
|/s/ Lawrence C. TuckerLawrence C. Tucker    |  | Director                                                                                     |  | March 26, 2002

50