<PAGE>

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

                                   FORM 10-Q

             [X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

                  For the quarterly period ended June 30, 2001

                                       OR

             [ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

                 For the transition period from _____ to _____

                          Commission File No. 0-27801

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

            Texas                                         75-2725998
(State or other jurisdiction of                        (I.R.S. Employer
 incorporation or organization)                       Identification No.)

                        222 West Las Colinas Boulevard
                                   Suite 450
                              Irving, Texas 75039
                  (Address, including zip code, of principal
                              executive offices)

                                (972) 869-0770
                   (Registrant's telephone number, including
                                  area code)

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

                        YES    X              NO
                             -----               -----

The registrant had 36,043,550 shares of Common Stock, par value $.001 per share,
outstanding as of June 30, 2001.

<PAGE>

PART I - FINANCIAL INFORMATION
<TABLE>
<CAPTION>

Item 1.    Condensed Financial Statements                                   Page
                                                                            ----
<S>                                                                         <C>
           Condensed Balance Sheets at June 30, 2001 (Unaudited) and
              March 31, 2001                                                  3

           Condensed Statements of Operations for the three months
              ended June 30, 2001 and 2000 (Unaudited)                        4

           Condensed Statements of Cash Flows for the three months
              ended June 30, 2001 and 2000 (Unaudited)                        5

           Notes to Condensed Financial Statements (Unaudited)                6

Item 2.    Management's Discussion and Analysis of Financial Condition
           and Results of Operations                                          9

           Risk Factors                                                      14

Item 3.    Quantitative and Qualitative Disclosures About Market Risk        26

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

PART II - OTHER INFORMATION

Item 6.   Exhibits and Reports on Form 8-K                                   27

          Signatures                                                         28

</TABLE>

                                       2
<PAGE>

                            Data Return Corporation
                            Condensed Balance Sheets
                     (in thousands, except per share data)

<TABLE>
<CAPTION>
                                                                                June 30,      March 31,
                                                                                  2001          2001
                                                                               -----------    ---------
Assets                                                                         (Unaudited)
<S>                                                                            <C>            <C>
Current assets:
     Cash                                                                        $  8,547      $  6,566
     Investment in marketable securities                                           11,349        26,800
     Accounts receivable, net of allowance for doubtful accounts
       of $933 and $1,589 at June 30, 2001 and March 31, 2001,
       respectively                                                                 6,837         8,477
     Prepaid and other                                                              1,210         1,189
                                                                                 --------      --------
Total current assets                                                               27,943        43,032
     Property and equipment, net                                                   42,529        44,104
     Other Assets                                                                     491           496
                                                                                 --------      --------
Total assets                                                                     $ 70,963      $ 87,632
                                                                                 ========      ========
Liabilities and shareholders' equity
Current liabilities:
     Accounts payable                                                            $  2,072      $  2,443
     Accrued expenses and other                                                     5,267         4,265
     Deferred revenue                                                               4,717         5,717
     Notes payable and capital lease obligations-current                           13,822        12,873
                                                                                 --------      --------
Total current liabilities                                                          25,878        25,298

Notes payable and capital lease obligations - long term                            16,744        18,173
Commitments and contingencies                                                           -             -
                                                                                 --------      --------
Total liabilities                                                                  42,622        43,471

Shareholders' equity:
     Preferred stock, $.001 par value; 20,000 shares
       authorized, none issued or outstanding                                           -             -
     Common stock, $.001 par value; 100,000 shares
       authorized; 36,044 and 35,979 issued and outstanding
       at June 30, 2001 and March 31, 2001,  respectively                              36            36
     Additional paid-in capital                                                   110,614       110,497
     Pre-paid broadband services                                                   (4,175)       (4,594)
     Deferred stock compensation                                                     (104)         (119)
     Accumulated deficit including comprehensive earnings                         (78,030)      (61,659)
                                                                                 --------      --------
Total shareholders' equity                                                         28,341        44,161
                                                                                 --------      --------
Total liabilities and shareholders' equity                                       $ 70,963      $ 87,632
                                                                                 ========      ========
</TABLE>
           See accompanying notes to Condensed Financial Statements

                                       3
<PAGE>

                            Data Return Corporation
                       Condensed Statements of Operations
                     (in thousands, except per share data)
                                   Unaudited

<TABLE>
<CAPTION>
                                                                               Three Months Ended
                                                                                     June 30
                                                                     ---------------------------------------
                                                                       2001                           2000
                                                                     --------                       --------
<S>                                                                  <C>                            <C>
Revenues                                                             $ 13,583                       $  9,080

Costs and expenses:
    Cost of revenue                                                    13,158                          9,011
    General and administrative                                          5,936                          4,231
    Marketing and sales                                                 6,886                          4,597
    Product research & development                                      1,219                            772
    Stock- based compensation                                              15                            100
    Restructuring costs                                                 2,191                              -
                                                                     --------                       --------
Total costs and expenses                                               29,405                         18,711
                                                                     --------                       --------
Loss from operations                                                  (15,822)                        (9,631)

Other income (expense):
    Interest income                                                       407                          1,226
    Interest expense                                                     (814)                          (445)
                                                                     --------                       --------
Loss before cumulative effect of change
in accounting principle                                              $(16,229)                      $ (8,850)

Cumulative effect of change in accounting
principle                                                                   -                         (1,626)
                                                                     --------                       --------
Net loss                                                             $(16,229)                      $(10,476)
                                                                     ========                       ========
Basic and diluted net loss per common share:
    Before cumulative effect of change in
    accounting principle                                             $  (0.45)                      $  (0.25)

    Cumulative effect of change in
    accounting principle                                             $      -                       $  (0.05)
                                                                     --------                       --------
Net loss per common share:
    Basic and diluted                                                $  (0.45)                      $  (0.30)
                                                                     ========                       ========
Shares used in computing basic and diluted net loss per share          36,018                         35,443
                                                                     ========                       ========
</TABLE>

           See accompanying notes to Condensed Financial Statements.

                                       4
<PAGE>

                            Data Return Corporation
                       Condensed Statements of Cash Flows
                     (in thousands, except per share data)
                                   Unaudited

<TABLE>
<CAPTION>

                                                                                  Three Months Ended June 30,
                                                                             ------------------------------------
                                                                               2001                         2000
                                                                             --------                     --------
<S>                                                                          <C>                          <C>
Operating activities:
Net loss                                                                     $(16,229)                    $(10,476)

Adjustments to reconcile net loss to net cash
      (used in) operations:
   Noncash items included in net loss:
      Depreciation and amortization                                             5,070                        2,368
      Stock based compensation expense                                             15                          100
      Provision for bad debts                                                     714                          221
      Amortization of warrants issued for services                                108                          139
      Loss on disposal of assets                                                   22                            -
   Changes in assets and liabilities
      Accounts receivable                                                         926                       (1,550)
      Prepaids and other assets                                                  (158)                      (1,260)
      Accounts payable and accrued expenses                                     1,050                          579
      Deferred revenue                                                         (1,000)                       2,881
                                                                             --------                     --------
Net cash (used in) operating activities                                        (9,482)                      (6,998)

Investing Activities:
      Capital expenditures                                                       (929)                      (4,878)
      Purchase of marketable securities                                             -                      (57,920)
      Sale of marketable securities                                            15,451                            -
      Restricted cash                                                               -                            -
                                                                             --------                     --------
Net cash provided by (used in) investing activities                            14,522                      (62,798)

Financing activities:
      Payments on notes payable and capital lease
      obligations                                                              (3,068)                      (1,903)
      Net proceeds from issuance of stock                                           9                           28
                                                                             --------                     --------
Net cash (used in) financing activities                                        (3,059)                      (1,875)
                                                                             --------                     --------

Net increase (decrease) in cash                                                 1,981                      (71,671)

      Beginning cash                                                            6,566                       85,424
                                                                             --------                     --------
      Ending cash                                                            $  8,547                     $ 13,753
                                                                             ========                     ========

Non cash activities:
      Equipment acquired under capital lease                                 $  2,602                     $  7,610
                                                                             ========                     ========
</TABLE>
           See accompanying notes to Condensed Financial Statements.

                                       5
<PAGE>

1.  Organization and Basis of Presentation

Organization

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

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

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

  The Company intends to implement a cost savings plan with an objective of
becoming substantially cash flow breakeven at the Company's current revenue
levels by reducing cash outflows. The Company expects this plan to include
significant reductions in personnel expenses, fixed operating expenses
(including capital and real estate leases) and discretionary expenses. This plan
is in addition to the restructuring plan described in footnote 7. The Company
currently expects that, if it is successful in executing this plan, its cash and
investment balances available at June 30, 2001 should be sufficient to meet its
working capital and capital expenditure requirements through the end of its
current fiscal year (March 31, 2002). The Company has developed this plan
because it has continued to experience lower than expected sales and has lost
customers at a higher rate than expected. The Company has begun to implement
certain components of this plan and intends to intensify its efforts in the
immediate future. However, the Company cannot assure you that it will be
successful in executing this plan. If the Company is not successful in
implementing this plan or if the Company is only partially successful in
implementing this plan (including as a result of not achieving the results of
operations that form the basis for the plan), then the Company will continue to
incur negative cash flows and will be required either to further curtail
significantly its current operations to enable it to continue as a going concern
or to secure additional sources of capital to continue operating at its current
level. To the extent the Company continues to incur negative cash flows, it will
be required to use its cash and other liquid resources to support its
operations. Whether or not the Company is successful in executing its plan, the
Company's operating activities on a long-term basis may require it to obtain
additional equity or debt financing. The Company finances under capital or
operating leases substantially all of the equipment it uses to provide services
to its customers. As a result, the Company's investments in this type of
equipment will require it to obtain additional lease or other financing in the
future. The Company's ability to obtain additional lease financing may be
impaired if it attempts to restructure its existing capital or operating lease
obligations. If the Company requires additional financing for any reason, there
can be no assurance that such additional financing will be available to it on
acceptable terms, or at all. If the Company requires additional capital and is
unable to raise it, the Company may be required to substantially reduce or
curtail operations.

Basis of Presentation

  The accompanying unaudited condensed financial statements have been prepared
in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X.  Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) necessary to present fairly the information set
forth therein have been included. Operating results for the three-month period
ended June 30, 2001 are not necessarily an indication of the results that may be
expected for the year ending March 31, 2002.

  The balance sheet at March 31, 2001 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements.

                                       6
<PAGE>

  The accompanying condensed financial statements should be read in conjunction
with the audited financial statements and footnotes included in the Company's
Annual Report on Form 10-K for the Year Ended March 31, 2001.

2.   Net Loss Per Share

  Basic and diluted net loss per share is computed using the weighted average
number of shares of common stock outstanding during each period.  Common stock
equivalents are not considered in the calculation of diluted net loss per share
as the Company has incurred a loss for all periods presented and the effect of
common stock equivalents would be anti-dilutive.   Thus, 10,184,948 employee
stock options and 345,910 warrants to acquire shares of common stock are not
included in this calculation.

3.   Recent Accounting Pronouncements

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

4.   Investments

  The Company has classified all of its debt securities as available-for-sale.
Available-for-sale securities are carried at fair value, with unrealized gains
and losses reported as a separate component of shareholders' equity net of
applicable income taxes. Realized gains and losses and declines in value judged
to be other-than-temporary on available-for-sale securities are included in
other income. The cost basis for realized gains and losses on available-for-sale
securities is determined on a specific identification basis.

  As of June 30, 2001, the Company owned approximately $11.3 million of debt
securities with maturity dates in fiscal year 2002.  As available-for-sale
securities, the $11.3 million of debt securities is carried on the Company's
books at fair value.  The company has an unrealized gain of  $139,000, a
decrease of $142,000 from March 31, 2001, on its available-for-sale securities
which is recorded as other comprehensive income in shareholders' equity.

5.   Property and Equipment

  Property and equipment consists of the following (in thousands):


<TABLE>
<CAPTION>
                                                                     June 30, 2001                  March 31, 2001
                                                                     -------------                  --------------
<S>                                                                  <C>                            <C>
Electronics and computer equipment.................................       $ 46,613                        $ 44,313
Computer software..................................................          4,032                           3,961
Furniture and office equipment.....................................          4,593                           4,592
Leasehold improvements.............................................          5,599                           5,767
Other depreciable assets...........................................          3,789                           2,547
                                                                          --------                        --------
                                                                            64,626                          61,180
Less accumulated depreciation and amortization.....................        (22,097)                        (17,076)
                                                                          --------                        --------
                                                                          $ 42,529                        $ 44,104
                                                                          ========                        ========
</TABLE>

                                       7
<PAGE>

  Property and equipment includes assets acquired under capital leases,
principally computer equipment with a cost of $43,520,000 at June 30, 2001 and
$40,918,000 at March 31, 2001, respectively.  Related allowances for
depreciation and amortization are $14,691,000 and $11,337,000 respectively.

6.   Accrued Expenses

  Accrued expenses consist of the following (in thousands):

<TABLE>
<CAPTION>
                                                                     June 30, 2001              March 31, 2001
                                                                     -------------              --------------
<S>                                                                  <C>                         <C>
Professional fees...................................................        $  207                      $  183
Marketing Costs.....................................................           955                       1,306
Accrued payroll.....................................................         1,137                       1,700
Commissions.........................................................           252                         137
Restructuring Costs.................................................         1,689                           -
Other...............................................................         1,027                         939
                                                                     -------------              --------------
                                                                            $5,267                      $4,265
                                                                     =============              ==============
</TABLE>


7.   Restructuring Costs

  On May 10, 2001, the Company initiated a restructuring plan intended to reduce
its workforce and eliminate excess office space and furniture and fixtures at
its headquarters. On May 11, 2001, the Company reduced its workforce by 94
employees. The Company also anticipates that it will renegotiate the lease for
its headquarters facilities and certain excess leased furniture and fixtures. As
a result of these activities, the Company has recorded as restructuring costs an
estimate of the cost to terminate certain of its leases. The Company has also
recorded a charge for the net book value of leasehold improvements related to
the excess office space at its headquarters facilities. These costs are outlined
in the schedule below.

<TABLE>
<S>                                                                  <C>
Costs associated with lease terminations............................ $1,690,000
Severance costs.....................................................    501,000
                                                                     ----------
                                                                     $2,191,000
                                                                     ==========
</TABLE>

8.   Contingencies

   The Company has been informed that two financial institutions have foreclosed
on, and as of July 26, 2001 had sold, an aggregate of approximately 2.1 million
shares of the Company's common stock pledged, directly or indirectly, by Sunny
C. Vanderbeck, its Chairman and Chief Executive Officer, to secure margin debt
owed to these institutions. As of July 26, 2001, a family limited partnership
controlled by Mr. Vanderbeck had margin debt of approximately $2.6 million with
one financial institution, which was secured by approximately 3.9 million shares
of the Company's common stock. In addition, as of July 26, 2001, Mr. Vanderbeck
had approximately $3.4 million in margin debt with a second financial
institution secured by approximately 2.1 million shares of the Company's common
stock. The Company has guaranteed up to $2.0 million of the debt owed by Mr.
Vanderbeck to the second financial institution. Pursuant to a letter agreement
with the limited partnership and Mr. Vanderbeck, if the Company is required to
pay any amounts under the guarantee, the limited partnership and Mr. Vanderbeck
would be required to repay any amounts paid by the Company under such guarantee.



                                       8
<PAGE>

ITEM 2.   Management's Discussion and Analysis of Financial Condition and
Results of Operations.

  The following discussion of the financial condition and results of operations
of Data Return should be read in conjunction with the condensed financial
statements and the related notes thereto included elsewhere in this Form 10-Q
and the Data Return Annual Report on form 10-K for the year ended March 31,
2001.

Forward-Looking Statements

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

Overview

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

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

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

  Services are billed on a monthly basis and, except as described below, are
recognized as the service is performed. As a result of our adoption of Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements ("SAB
101"), revenues from set-up, or installation, services are recognized over the
longer of the length of the customer contract and the estimated life of the
customer contract. See "Recent Accounting Pronouncements" for a description of
our adoption and the effect of SAB 101.

  Our expenses are comprised of:

                                       9
<PAGE>

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

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

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

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

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

     .  restructuring costs, which consists primarily of severance compensation
        and related expenses, occupancy costs and restructuring costs on assets.

   We have incurred significant losses since our inception and, as of June 30,
2001, had an accumulated deficit of approximately $78.0 million. We expect to
continue to incur substantial losses for the foreseeable future. We may not be
able to successfully execute our plans.

Results of Operations

Comparison of quarters ended June 30, 2001 and 2000

Revenues

  Our revenues increased $4,503,000 to $13,583,000 for the quarter ended June
30, 2001 from $9,080,000 for the quarter ending June 30, 2000. Dedicated hosting
revenue and managed services fees increased $4,613,000 to $11,471,000, or 84.5%
of revenue, for the quarter ended June 30, 2001 from $6,858,000, or 75.4% of
revenue, for the quarter ended June 30, 2000.  Shared hosting revenue decreased
$131,000 to $662,000, or 4.9% of revenue, for the quarter ended June 30, 2001
from $793,000, or 8.6% of revenue, for the quarter ended June 30, 2000.  Set-up
fees decreased $175,000 to $721,000, or 5.31% of revenue, for the quarter ended
June 30, 2001 from $896,000, or 9.9% of revenue, for the quarter ended June 30,
2000.  Revenues from testing and other lab services were $315,000 for the
quarter ended June 30, 2001 reflecting the opening of our scalability lab in
September 2000.  The increase was primarily due to the addition of new customers
that generated higher average monthly revenues. Growth from some existing
customer accounts also contributed.

Cost of revenue

  Our cost of revenue increased $4,147,000 to $13,158,000, or 96.9% of revenue,
for the quarter ended June 30, 2001 from $9,011,000, or 99.2% of revenue, for
the quarter ended June 30, 2000. The increase in cost of revenue was due
primarily to increases in personnel and related costs, depreciation and
amortization expenses, communication and bandwidth expenses, other hardware and
software equipment costs, facilities, travel and professional services.
Personnel and related expenses increased approximately $286,000 to $4,792,000,
or 35.3% of revenue, for the quarter ended June 30, 2001 from $4,506,000, or
49.6% of revenue, for the quarter ended June 30, 2000, as we decreased our
systems and customer support personnel to 205 at June 30, 2001 from 237 at June
30, 2000. Personnel and related expenses increased despite a smaller number of
systems and customer support personnel at the end of the quarter primarily
because of the timing of our reduction in work force during the first quarter of
fiscal 2002.  Depreciation and amortization expenses increased approximately
$1,845,000 to $3,860,000 for the quarter ended June 30, 2001, as we added
approximately $20.3 million in computer and related equipment since June 30,
2000. Our communication and bandwidth expenses increased $2,058,000 to
approximately $3,542,000 for the

                                       10
<PAGE>

quarter ended June 30, 2001 from $1,484,000 for the quarter ended June 30, 2000
to support our increased business activities. Other hardware and software
equipment costs increased $251,000 to $689,000 for the quarter ended June 30,
2001 to support the growth in our business. Expenses for facilities, travel and
professional services decreased $146,000, $82,000 and $57,000 to $208,000,
$46,000 and $17,000, respectively, for the quarter ended June 30, 2001.

General and administrative

  General and administrative expense increased $1,705,000 to $5,936,000, or
43.7% of revenue, during the quarter ended June 30, 2001 from $4,231,000, or
46.6% of revenue, during the quarter ended June 30, 2000. The increase is
primarily due to increases in personnel and related expenses, facilities
expense, depreciation and amortization and bad debt expense. Personnel and
related expenses increased $87,000 to $2,605,000, or 19.2% of revenue, for the
quarter ended June 30, 2001 from $2,518,000, or 27.7% of revenue, for the
quarter ended June 30, 2000. We decreased our number of employees in general and
administrative functions to 89 employees at June 30, 2001 from 104 employees at
June 30, 2000. Facilities expense increased $510,000 to $782,000 as a result of
our move into a larger facility and the growth in average the number of general
and administrative employees during the first quarter of fiscal 2001.
Depreciation and amortization expense increased $357,000 to $587,000 in the
quarter ended June 30, 2001, which is a result of increased internal equipment
necessary to support the growth of our business. Bad debt expense increased
$493,000 to $714,000 in the quarter ended June 30, 2001 as many of our customers
ceased operations or reduced or eliminated the web site operations hosted by us.
We expect our financial results, including bad debt expense, to continue to be
negatively impacted by the termination or reduction in service by our customers.

Marketing and sales

  Marketing and sales expense increased $2,289,000 to $6,886,000, or 50.7% of
revenue, during the quarter ended June 30, 2001 from $4,597,000, or 50.6% of
revenue, during the quarter ended June 30, 2000. The increase was due primarily
to an increase in marketing and sales personnel and related expenses,
advertising costs, including agency fees, trade shows and promotional items,
travel expenses, depreciation expenses, and facilities expenses.  Personnel and
related expenses increased $1,034,000 to $3,848,000, or 28.3% of revenue, for
the quarter ended June 30, 2001 from $2,814,000, or 31.0% of revenue, for the
quarter ended June 30, 2000. Advertising costs increased $650,000 to
$1,830,000 for the quarter ended June 30, 2001 from $1,180,000 for the quarter
ended June 30, 2000. Costs in this category include expenses for our direct
marketing and lead-generation program, advertising, promotional items, trade
shows, and fees paid to advertising, public relations and other creative
agencies.  Travel expenses increased $156,000 to $513,000 for the quarter ended
June 30, 2001 as a result of the growth in the number of marketing and sales
personnel. Depreciation and facilities expenses increased $251,000 and $88,000,
to $294,000 and $212,000, respectively, for the quarter ended June 30, 2001 due
to our move into a larger facility.   We increased our marketing and sales
personnel to 108 at June 30, 2001 from 65 at June 30, 2000.

Product research and development

  Product research and development expense increased $447,000 to $1,219,000, or
9.0% of revenue, during the quarter ended June 30, 2001 from $772,000, or 8.5%
of revenue, during the quarter ended June 30, 2000.  The increase was due
primarily to an increase in product research and development personnel and
related expenses, facilities, depreciation and amortization and travel expenses.
Personnel and related expenses increased $296,000 to $953,000, or 7.0% of
revenue for the quarter ended June 30, 2001 from $657,000, or 7.2% of revenue,
for the quarter ended June 30, 2000.  We increased our number of employees in
product research and development to 45 at June 30, 2001 from 40 at June 30,
2000.  Facilities, depreciation and amortization and travel expenses increased
$58,000, $30,000 and $2,000 to $98,000, $64,000 and $31,000, respectively, for
the quarter ended June 30, 2001 as a result of our move into a larger facility
and the increase in the number of product research and development employees.

                                       11
<PAGE>

Stock-based compensation

  Deferred stock compensation was recorded in connection with the grant of
employee stock options below fair value in 1998 and 1999. Amortization of stock-
based compensation totaled $15,000 for the quarter ended June 30, 2001 and
$100,000 for the quarter ended June 30, 2000. The amortization of stock-based
compensation is based on the vesting schedule of stock options held by our
employees.

Restructuring costs

  On May 10, 2001, we initiated a restructuring plan intended to reduce our
workforce and eliminate excess office space and furniture and fixtures at our
headquarters. On May 11, 2001, we reduced our workforce by 94 employees. We also
anticipate that we will renegotiate the lease for our headquarters facilities
and certain excess leased furniture and fixtures. As a result of these
activities, we have recorded as restructuring costs an estimate of the cost to
terminate certain of our leases. We have also recorded a charge for the net book
value of leasehold improvements related to the excess office space at our
headquarters facilities. The reduction in workforce was a result of slower than
anticipated growth and increased process and other operational efficiencies.

  Restructuring costs were $2,191,000 during the quarter ended June 30,2001.
Restructuring costs consisted of estimated costs associated with termination of
leases of $1,690,000 and severance costs of $501,000.

Other income (expense)

  Other income (expense) consists primarily of interest income on our cash
balances and investments in marketable securities and interest expense on our
outstanding notes payable and capital lease obligations. Interest earned on our
cash and cash equivalents decreased $819,000 to $407,000 for the quarter ended
June 30, 2001 from $1,226,000 for the quarter ended June 30, 2000. This decrease
was due primarily to having lower cash balances for investments as cash has been
used to fund operating losses. During the quarter ended June 30, 2001, interest
expense increased $369,000 to $814,000 related primarily to equipment acquired
under capital leases during the last four quarters.

Income taxes

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

Cumulative effect of change in accounting principle

  Effective April 1, 2000, we changed our method of accounting for set-up fees
in accordance with SAB 101. We recorded a cumulative effect adjustment of $1.6
million as of April 1, 2000 and amortized set-up fees into revenues during
fiscal 2001. Set-up fees are now amortized over the longer of the length of the
customer contract and the estimated life of the customer contract.

Net loss

  Net loss increased $5,753,000 to $16,229,000 for the quarter ended June 30,
2001 from $10,476,000 for the quarter ended June 30, 2000. As more fully
discussed above, the increased net loss is primarily attributable to

                                       12
<PAGE>

increased costs as we continued to build our business for anticipated growth.

EBITDA

  EBITDA, as defined below, decreased $3,606,000 to negative $10,630,000 for the
quarter ended June 30, 2001 from negative $7,024,000 for the quarter ended June
30, 2000.  The decrease is primarily attributable to costs associated with our
growth strategy. We expect to generate negative EBITDA for fiscal 2002. Costs
associated with our personnel and our fixed commitments will continue to
represent a large portion of our expenses during our anticipated expansion.

  EBITDA for the quarters ended June 30, 2001 and 2000 consists of loss from
operations of $15,822,000 and $9,631,000 plus depreciation and amortization of
$5,177,000 and $2,507,000 and amortization of unearned stock-based compensation
of $15,000 and $100,000, respectively. EBITDA does not represent funds available
for management's discretionary use and is not intended to represent cash flow
from operations as measured under generally accepted accounting principles.
EBITDA should not be considered as an alternative to net loss or net cash used
in operating activities, but may be useful to investors as an indication of
operating performance. This caption excludes components that are significant in
understanding and assessing the results of operations and cash flows. In
addition, EBITDA is not a term defined by generally accepted accounting
principles and, as a result, our calculations of EBITDA may not be consistent
with calculations of EBITDA used by others. However, we believe that EBITDA is
relevant and useful information that is often reported and widely used by
analysts, investors and other interested parties in the advanced hosting
industry. Accordingly, we are disclosing this information to permit a more
comprehensive analysis of our operating performance, as an additional meaningful
measure of performance and liquidity and to provide additional information with
respect to our ability to meet future working capital requirements.

Liquidity and Capital Resources

  We have historically financed our operations primarily through sales of equity
securities and capital leases. Since our inception, we have raised $15.9 million
through private placements of our common stock. In November 1999, we raised
$85.9 million in net proceeds from our initial public offering. As of June 30,
2001, we had cash and cash equivalents of $8.5 million and investments in
marketable securities of $11.3 million.

  Net cash used in our operating activities for the three-month period ended
June 30, 2001 was $9.5 million. The net cash used in operations was comprised
primarily of working capital requirements and our net loss, net of depreciation
and amortization. Net cash provided by investing activities was $14.5 million
for the three-month period ended June 30, 2001 and consisted of the sale of
marketable debt securities of $15.5 million and purchases of property and
equipment of approximately $929,000. Our purchases of property and equipment
consisted primarily of leasehold improvements and equipment to provide services
to our customers. We acquired $2.6 million in computer and related equipment
under capital leases for the three-month period ended June 30, 2001. Net cash
used in financing activities was approximately $3.1 million for the three-month
period ended June 30, 2001 and consisted primarily of principal payments on our
notes payable and capital leases.

  Total borrowings under our notes payable and capital lease obligations as of
June 30, 2001 were approximately $30.6 million.

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

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

                                       13
<PAGE>

2001, $400,000 per quarter during the next 12 months, $600,000 per quarter
during the next 12 months and $1.0 million per quarter during the final 12
months of the agreement.

  We intend to implement a cost savings plan with an objective of becoming
substantially cash flow breakeven at our current revenue levels by reducing cash
outflows. We expect this plan to include significant reductions in personnel
expenses, fixed operating expenses (including capital and real estate leases)
and discretionary expenses. This plan is in addition to the restructuring plan
described above. We currently expect that, if we are successful in executing
this plan, our cash and investment balances available at June 30, 2001 should be
sufficient to meet our working capital and capital expenditure requirements
through the end of our current fiscal year (March 31, 2002). We have developed
this plan because we have continued to experience lower than expected sales and
have lost customers at a higher rate than expected. We have begun to implement
certain components of this plan and intend to intensify our efforts in the
immediate future. However, we cannot assure you that we will be successful in
executing this plan. If we are not successful in implementing this plan or if we
are only partially successful in implementing this plan (including as a result
of not achieving the results of operations that form the basis for the plan),
then we will continue to incur negative cash flows and will be required either
to further curtail significantly our current operations to enable us to continue
as a going concern or to secure additional sources of capital to continue
operating at our current level. To the extent we continue to incur negative cash
flows, we will be required to use our cash and other liquid resources to support
our operations. Whether or not we are successful in executing our plan, our
operating activities on a long-term basis may require us to obtain additional
equity or debt financing. We finance under capital or operating leases
substantially all of the equipment we use to provide services to our customers.
As a result, our investments in this type of equipment will require us to obtain
additional lease or other financing in the future. Our ability to obtain
additional lease financing may be impaired if we attempt to restructure our
existing capital or operating lease obligations. If we require additional
financing for any reason, there can be no assurance that such additional
financing will be available to us on acceptable terms, or at all. If we require
additional capital and are unable to raise it, we may be required to
substantially reduce or curtail operations.

Recent Developments

  We have guaranteed up to $2.0 million of margin debt owed by a family limited
partnership controlled by our Chairman of the Board and Chief Executive Officer,
Sunny C. Vanderbeck, to a financial institution. We have been informed that this
financial institution and another financial institution have foreclosed on, and
as of July 26, 2001 had sold, an aggregate of approximately 2.1 million shares
of our common stock pledged, directly or indirectly, by Mr. Vanderbeck to secure
margin debt owed to these institutions. As of July 26, 2001, the family limited
partnership had margin debt of approximately $3.4 million in margin debt with
the financial institution that is the beneficiary of the guarantee. This margin
debt is secured by approximately 2.1 million shares of our common stock. In
addition, as of July 26, 2001, the limited partnership had approximately $2.6
million of margin debt with a second financial institution, which was secured by
approximately 3.9 million shares of our common stock. Pursuant to a letter
agreement with the limited partnership and Mr. Vanderbeck, if we are required to
pay any amounts under the guarantee, the limited partnership and Mr. Vanderbeck
would be required to repay any amounts paid by us under such guarantee.

Recent Accounting Pronouncements

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

Risk Factors

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

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

  We have experienced operating losses and negative cash flows from operations
in each quarterly and annual period since incorporating in 1997. We experienced
net losses of approximately $16.2 million, or negative 119% of revenues, for
the quarter ended June 30, 2001. As of June 30, 2001, we had an accumulated
deficit of approximately $78.0 million. We are required to purchase $900,000 of
colocation and bandwidth services from Level 3 during the fiscal 2002. We expect
to incur operating losses for at least the next fiscal year. We cannot assure
you that we will ever be profitable on a quarterly or annual basis or that, if
we achieve profitability, it will be sustainable.

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

  We intend to implement a cost savings plan with an objective of becoming
substantially cash flow breakeven at our current revenue levels by reducing cash
outflows.  We expect this plan to include significant reductions in personnel
expenses, fixed operating expenses (including capital and real estate leases)
and expenses.  We currently expect that, if we are successful in executing this
plan, our cash and investment balances available at June 30, 2001 should be
sufficient to meet our working capital and capital expenditure requirements
through the end of our current fiscal year (March 31, 2002). We have developed
this plan because we have continued to experience lower than expected sales and
have lost customers at a higher rate than expected.  We have begun to implement
certain components of this plan and intend to intensify our efforts in the
immediate future.    However, we cannot assure you that we will be successful in
executing this plan.  If we are not successful in implementing this plan or if
we are only partially successful in implementing this plan (including as a
result of not achieving the results of operations that form the basis for the
plan), then we will continue to incur negative cash flows and will be required
either to further curtail significantly our current operations to enable us to
continue as a going concern or to secure additional sources of capital to
continue operating at our current level. To the extent we continue to incur
negative cash flows, we will be required to use our cash and other liquid
resources to support our operations. Whether or not we are successful in
executing our plan, our operating activities on a long-term basis may require us
to obtain additional equity or debt financing. We finance under capital or
operating leases substantially all of the equipment we use to provide services
to our customers. As a result, our investments in this type of equipment will
require us to obtain additional lease or other financing in the future. Our
ability to obtain additional lease financing may be impaired if we attempt to
restructure our existing capital or operating lease obligations.  In addition,
if we expand our existing business plan to focus on growth in international
markets, make acquisitions of businesses or technologies or modify our business
plan in other ways, we would likely require additional funding. If we require
additional financing for any reason, there can be no assurance that such
additional financing will be available to us on acceptable terms, or at all. If
we require additional capital and are unable to raise it, we may be required to
substantially reduce or curtail operations. Further, if additional funds are
raised through the issuance of additional equity securities, the percentage
ownership of our shareholders would be diluted. Any new equity securities may
have rights, preferences or privileges senior to those of our common stock.

                                       14
<PAGE>

us to continue as a going concern. In addition, we may require additional funds
during or after that period. In particular, we would be required to secure
additional sources of capital to continue operating at our current level or
curtail our current operations if we do not achieve the results of operations
that we expect as a result of lower than expected revenues, higher than expected
expenses or other possible adverse developments. In addition, if we expand our
existing business plan to focus on growth in markets, make acquisitions of
businesses or technologies or modify our business plan in other ways, we would
likely require additional funding. If we require additional financing for any
reason, there can be no assurance that such additional financing will be
available to us on acceptable terms, or at all. In the event we are unable to
raise additional capital, we may be required to substantially reduce or curtail
operations. Further, if additional funds are raised through the issuance of
additional equity securities, the percentage ownership of our shareholders would
be diluted. Any new equity securities may have rights, preferences or privileges
senior to those of our common stock.

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

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

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

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

    .  demand for our services;

    .  size and timing of customer installations and related payments;

    .  reliable services and network availability;

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

    .  fluctuations in data and voice communications costs;

    .  fluctuations in hardware and software costs;

    .  timing and magnitude of capital expenditures and other expenses;

    .  costs relating to operations;

    .  customer retention and satisfaction;

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

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

                                       15
<PAGE>

    .  customer discounts and credits;

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

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

    .  retention of our key personnel; and

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

A portion of our operating costs are fixed. If our revenues do not exceed our
costs, our operating results will suffer.

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

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

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

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

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

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

                                       16
<PAGE>

be inhibited, and we may be unable to sustain growth in our customer base for a
number of reasons, including:

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

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

    .  our inability to strengthen awareness of our brand; and

    .  reliability, quality or compatibility problems with our services.

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

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

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

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

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

                                       17
<PAGE>

have a written agreement with Microsoft relating to all of these certifications
or designations. Some of our competitors also have received these certifications
and designations. Microsoft generally confers these certifications unilaterally
and in its sole discretion and could change them at any time. We cannot be
certain that we will continue to enjoy them.

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

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

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

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

    .  take advantage of acquisition and other opportunities more readily;

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

    .  adopt more aggressive pricing policies.

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

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

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

If we are unable to expand our network infrastructure when needed, we could lose
customers and our operating results could suffer.

     We may have to expand and adapt our network infrastructure to accommodate
our customers' requirements, the amount of information they wish to transmit and
their changing requirements. We face risks related to our network's ability to
be scaled to meet these requirements while maintaining acceptable performance
levels. The continued expansion and adaptation of our networking and hosting
infrastructure will continue to require substantial financial, operational and
management resources as we negotiate bandwidth capacity with existing and other
network infrastructure suppliers. If we are required to expand our network
significantly and rapidly due to increased usage, additional stress will be
placed upon our network hardware, traffic management systems and hosting
facilities as well as our financial, operational and management resources. The
ability of our network to support a substantially larger number of customers at
high transmission speeds is unknown. Furthermore, it may be difficult for us to
increase quickly our network capacity in light of current lead times to purchase
circuits and other
                                       18
<PAGE>

critical items. If the network providers upon which we rely fail to provide
reliability, capacity and performance for our network, we could lose customers
and our operating results could suffer.

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

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

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

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

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

     We depend on other companies to supply key components of our network
infrastructure. Any failure to obtain needed products or services in a timely
fashion or at an acceptable cost could adversely affect our business. We buy
servers, routers and switches on an as-needed basis and therefore do not carry
significant inventories of them. We also have no guaranteed supply arrangements
with our vendors. We currently only use servers from Compaq and rely on Compaq
to provide us with access to Compaq technical personnel. In July 1999, we
entered into an agreement with Compaq under which we agreed during the
immediately following three years to purchase from Compaq the lesser of 2,000
servers or the number of servers reasonably necessary to adequately operate our
business consistent with our business plan. Through June 30, 2001, we had
purchased approximately 1,870 servers from Compaq under this agreement. Our
requirement to purchase these servers is contingent upon Compaq providing
financing for the servers on competitive terms, upon the price, performance and
quality of the Compaq servers being reasonably satisfactory to us and upon
Compaq's commitment to deliver these servers on the schedule we request. In
addition, we rely on Cisco Systems, Inc. and others to supply equipment critical
to our network, but we do not have a supply agreement with any of them. If this
equipment were to become unavailable on terms acceptable to us, we would be
forced to find alternative equipment. The inability to obtain equipment or
technical services from Compaq, Cisco or others on terms acceptable to us would
force us to spend time and money selecting and obtaining new equipment, training
our personnel to use different equipment and deploying alternative components
needed to integrate the new equipment, and as a result our business could be
adversely affected. In addition, if our sole or limited source suppliers do not
provide products or components that comply with evolving Internet and
telecommunications standards or that interoperate with other products or
components we use, our

                                       19
<PAGE>

business would be harmed. For example, we have experienced performance problems,
including previously unknown software and firmware bugs, with routers and
switches that have caused disruptions in and impairment of network performance.

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

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

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

     We cannot assure you that we will not experience difficulties that could
delay or prevent the successful development, introduction or marketing of
Internet technologies in the future. If any newly introduced Internet
technologies or our service offerings suffer from reliability, quality or
compatibility problems, market acceptance of our services could be greatly
hindered and our ability to attract new customers could be adversely affected.
In addition, technological advances may have the effect of encouraging our
customers or prospective customers to rely on in-house personnel and equipment
to provide the services we provide.  We cannot assure you that new applications
or services deployed by us will be free from any reliability, quality or
compatibility problems. If we incur increased costs or are unable, for technical
or other reasons, to offer and deploy new Internet technologies or enhancements
of existing technologies, our ability to successfully market our services could
be substantially impaired.

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

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

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

     .  inadequate network infrastructure;

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

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

                                       20
<PAGE>

     .  inconsistent quality of service;

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

     .  failure of Internet-based businesses;

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

     .  failure of Internet use to expand internationally.

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

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

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

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

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

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

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

                                       21
<PAGE>

retain and attract qualified personnel on a cost-efficient basis, our operations
and financial results could be adversely affected.

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

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

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

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

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

     .  damage our reputation for reliable service;

     .  cause existing customers to cancel their contracts; or

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

Any of these results could damage our business.

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

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

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

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

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

     Unauthorized access, computer viruses, denial of service attacks,
accidents, misconduct resulting in disruptions and other disruptions could
occur. In addition, we may incur significant costs to prevent breaches in
security or to alleviate problems caused by breaches. We work with Level 3 and
other colocation vendors to protect our equipment

                                       22
<PAGE>

and hardware against breaches in physical security and with other vendors of
software and hardware to protect other breaches in security. We cannot be
certain that they will provide adequate security. We have experienced and may in
the future experience delays or interruptions in service as a result of the
accidental or intentional actions of Internet users, current and former
employees of Data Return or others. Furthermore, inappropriate use of the
network by third parties could also jeopardize the security of confidential
information, such as customer and Data Return passwords as well as credit card
and bank account numbers, stored in our computer systems or those of our
customers. As a result, we could become liable to others and lose existing or
potential customers. The costs required to eliminate computer viruses and
alleviate other security problems could be prohibitively expensive. In addition,
the efforts to address these problems could result in interruptions, delays or
cessation of service to our customers.

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

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

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

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

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

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

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

     The success of our business depends on the growth of the Internet. Laws and
regulations directly applicable to commerce or communications over the Internet
are becoming increasingly prevalent. However, the law of the Internet remains
largely unsettled. The adoption or modification of laws or regulations relating
to the Internet could adversely affect our business if they impose a direct cost
on us or if they curtail the growth of the Internet. If liability for materials
carried on or disseminated through their systems is imposed on service
providers, we would make

                                       23
<PAGE>

efforts to implement measures to reduce our exposure to such liability. Such
measures could require us to expend substantial resources or discontinue certain
product or service offerings. In addition, increased attention to liability
issues, as a result of lawsuits, legislation and legislative proposals, could
divert management attention, result in unanticipated expenses and harm our
business. If legislation is adopted in the U.S. or internationally that makes
transacting business over the Internet, such as e-commerce, less favorable or
otherwise curtails the growth of the Internet, our business would suffer.

We may be subject to legal claims in connection with the information
disseminated through our network which could have the effect of diverting
management's attention and require us to expend significant financial resources.

     We may face potential direct and indirect liability for claims of
defamation, negligence, copyright, patent or trademark infringement, violation
of securities laws and other claims based on the nature and content of the
materials disseminated through our network. For example, lawsuits may be brought
against us claiming that content distributed by some of our current or future
customers may be regulated or banned. In these and other instances, we may be
required to engage in protracted and expensive litigation which could have the
effect of diverting management's attention and require us to expend significant
financial resources. Our liability insurance may not cover any of these claims
or may not be adequate to protect us against all liability that may be imposed
or claimed.

     In addition, on a limited number of occasions in the past, businesses,
organizations and individuals have sent unsolicited commercial e-mails from
servers hosted at our facilities to massive numbers of people, typically to
advertise products or services. This practice, known as "spamming," can lead to
complaints against service providers that enable such activities, particularly
where recipients view the materials received as offensive. We have in the past
received, and may in the future receive, letters from recipients of information
transmitted by our customers objecting to such transmission. Although we
prohibit our customers by contract from spamming, we cannot assure you that our
customers will not engage in this practice, which could subject us to claims for
damages.

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

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

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

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

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

     .  challenges in staffing and managing foreign operations;

     .  differences in technology standards;

     .  less protective intellectual property laws;

     .  employment laws and practices in foreign countries;

     .  longer payment cycles and problems in collecting accounts receivable;

                                       24
<PAGE>

     .  political instability;

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

     .  potentially adverse tax consequences.

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

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


Our principal shareholders, directors and executive officers currently own
approximately 63.2% of our common stock, which may allow them to exert influence
over us or to prevent a change of control.

  Our directors and executive officers and shareholders who currently own over
5% of our common stock collectively beneficially own approximately 63.2% of our
outstanding common stock. These shareholders would be able to exercise
significant influence over all matters requiring shareholder approval, including
the election of directors and approval of significant corporate transactions.
This concentration of ownership could also delay or prevent a change in control
of Data Return even if beneficial to our shareholders.

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

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

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

     .  prohibit certain shareholder actions by written consent;

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

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

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

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

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

                                       25
<PAGE>

   At June 30, 2001, 36,043,550 shares of our common stock were issued and
outstanding. We cannot be sure what effect, if any, future sales of our common
stock or the availability of shares for future sale will have on the market
price of our common stock. The market price of our common stock could drop due
to sales of a large number of shares of our common stock in the market or the
perception that these sales could occur. These factors could also make it more
difficult to raise funds through future offerings of our common stock.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.

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

                                       26
<PAGE>

                          PART II - OTHER INFORMATION


Item 6.  Exhibits and Reports on Form 8-K.

(a)  Exhibits:

        None

(b)  Reports on Form 8-K:

        None

                                       27
<PAGE>

                                   SIGNATURES
                                   ----------


Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.


                              Data Return Corporation



Dated: August 14, 2001      By:  / s/ Stuart A. Walker
                                -------------------------------------------
                                Stuart A. Walker, Vice President
                                Chief Financial Officer
                                (Principal Financial & Accounting Officer &
                                Authorized Officer)

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