<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 December 31, 1999

                                      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              NO   X
    -----           -----

The registrant had 35,398,004 shares of Common Stock, par value $.001 per share,
outstanding as of February 11, 2000.
<PAGE>

PART I - FINANCIAL INFORMATION

Item 1.  Condensed Financial Statements                                     Page
                                                                            ----

     Condensed Balance Sheets at December 31, 1999 and March 31, 1999
               (Unaudited)                                                     2

     Condensed Statements of Operations for the three months and nine
               months ended December 31, 1999 and 1998 (Unaudited)             3

     Condensed Statements of Cash Flows for the nine months ended
               December 31, 1999 and 1998 (Unaudited)                          4

     Notes to Condensed Financial Statements (Unaudited)                       5

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

Item 3.  Quantitative and Qualitative Disclosures About Market Risk           25


PART II - OTHER INFORMATION

Item 6.  Exhibits and Reports on Form 8-K                                     26

         Signatures                                                           26

                                       1
<PAGE>

                        PART I - FINANCIAL INFORMATION.

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

<TABLE>
<CAPTION>
                                                                   December 31,                  March 31,
                                                                       1999                        1999
                                                                   -----------                  ----------
Assets                                                             (Unaudited)                   (Note 1)
------
<S>                                                                <C>                          <C>
Current assets:
   Cash                                                             $   92,781                   $     843
   Restricted cash                                                           -                         125
   Accounts receivable, net of allowance for doubtful
       accounts of $234 and $20 at December 31, 1999
       and March 31, 1999, respectively                                  2,656                         369
   Prepaid and other                                                     1,086                          28
                                                                    ----------                   ---------
Total current assets                                                    96,523                       1,365
   Property and equipment, net                                           9,876                         826
   Other assets                                                            374                          23
                                                                    ----------                   ---------
Total assets                                                        $  106,773                   $   2,214
                                                                    ==========                   =========

Liabilities and shareholders' equity
Current liabilities:
   Accounts payable                                                 $    1,466                   $     289
   Accrued expenses and other                                            1,285                         133
   Deferred revenue                                                      1,153                         286
   Notes payable and capital lease obligations                           2,249                          95
                                                                    ----------                   ---------
Total current liabilities                                                6,153                         803

Notes payable and capital lease obligations                              4,579                         166
Commitments and contingencies                                                -                           -
Shareholders' equity:
   Preferred stock, $.001 par value; 20,000 shares
       authorized, none issued or outstanding                                -                           -
   Common stock, $.001 par value; 100,000 shares
       authorized; 35,398 and  20,552 issued and
       outstanding at December 31, 1999 and
       March 31, 1999, respectively                                         35                          21
   Additional paid-in capital                                          111,640                       3,893
   Deferred broadband services                                          (5,000)                          -
   Deferred product development                                         (2,026)                          -
   Deferred stock compensation                                            (542)                     (1,195)
   Accumulated deficit                                                  (8,066)                     (1,474)
                                                                    ----------                   ---------
Total shareholders' equity                                              96,041                       1,245
                                                                    ----------                   ---------
Total liabilities and shareholders' equity                          $  106,773                   $   2,214
                                                                   ===========                   =========

</TABLE>

           See accompanying notes to Condensed Financial Statements.

                                       2
<PAGE>

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

<TABLE>
<CAPTION>
                                                         Three Months                                Nine Months
                                                            Ended                                       Ended
                                                         December 31,                                December 31,
                                                         ------------                                ------------
                                                    1999              1998                      1999              1998
                                                  --------          --------                  --------          --------
<S>                                               <C>               <C>                       <C>               <C>
Revenues                                          $  3,414           $   467                  $  6,367           $ 1,114

Costs and expenses:
   Cost of revenue                                   3,090               280                     4,861               728
   General and administrative                        2,087               243                     4,176               667
   Selling and marketing                             1,854               163                     3,306               433
   Stock based compensation                          1,230                86                     1,527               257
                                                  --------          --------                  --------          --------
Total costs and expenses                             8,261               772                    13,870             2,085
                                                  --------          --------                  --------          --------
Loss from operations                                (4,847)             (305)                   (7,503)             (971)
Other income (expense):
   Interest income                                     892                 3                     1,003                14
   Interest expense                                    (78)               (4)                      (90)               (8)
                                                  --------          --------                  --------          --------

Net Loss                                          $ (4,033)         $   (306)                 $ (6,590)         $   (965)
                                                  ========          ========                  ========          ========

Net loss per common share:
   Basic and diluted                              $  (0.12)         $  (0.02)                 $  (0.24)         $  (0.05)
                                                  ========          ========                  ========          ========
Shares used in computing basic and
diluted net loss per share                          32,833            17,850                    27,239            17,679
                                                  ========          ========                  ========          ========

</TABLE>

           See accompanying notes to Condensed Financial Statements.

                                       3
<PAGE>

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

<TABLE>
<CAPTION>

                                                                         Nine Months Ended December 31,
                                                                         ------------------------------
                                                                         1999                      1998
                                                                     -----------                ----------
<S>                                                                  <C>                        <C>
Operating activities:
Net Loss                                                               $  (6,590)                 $   (965)

Adjustment to reconcile net loss to net cash
       used in operations:
   Noncash items included in net loss:
       Depreciation and amortization                                         912                        77
       Stock based compensation expense                                    1,527                       257
       Provision for bad debts                                               234                        19
   Changes in assets and liabilities
       Account receivable                                                 (2,522)                     (188)
       Prepaids and other assets                                          (1,409)                      (20)
       Accounts payable                                                    1,177                       127
       Accrued expenses                                                    1,153                         -
       Deferred revenue                                                      867                       125
                                                                       ---------                  --------

Net cash used in operations                                               (4,651)                     (568)
                                                                       ---------                  --------

Cash flows from investing activities
   Capital expenditures                                                   (3,311)                     (373)
   Restricted cash                                                           125                      (125)
                                                                       ---------                  --------
Net cash used in investing activities                                     (3,186)                     (498)
                                                                       ---------                  --------

Financing activities:
   Proceeds from notes payable                                                 -                       132
   Payments on notes payable and capital lease obligations                   (12)                      (30)
   Net proceeds from issuance of stock                                    99,787                       775
                                                                       ---------                  --------
Net cash provided by financing activities                                 99,775                       877
                                                                       ---------                  --------

Net increase (decrease) in cash                                           91,938                      (189)

   Beginning cash                                                            843                       474
                                                                       ---------                  --------
   Ending cash                                                         $  92,781                  $    285
                                                                       =========                  ========

</TABLE>

           See accompanying notes to Condensed Financial Statements.

                                       4
<PAGE>

                            Data Return Corporation
                    Notes to Condensed Financial Statements
                                   Unaudited


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 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 and networking equipment is primarily located
in several facilities owned by one of its vendors. The vendor provides data
center facilities and bandwidth connectivity to the Company on a contractual
basis.

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- and nine-
month periods ended December 31, 1999 are not necessarily an indication of the
results that may be expected for the year ending March 31, 2000.

     The balance sheet at March 31, 1999 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.

     The accompanying condensed financial statements should be read in
conjunction with the audited financial statements and footnotes included in the
Prospectus dated October 27, 1999.

2.   Net Loss Per Share

     The Company computes net loss per share in accordance with SFAS No. 128,
"Earnings Per Share" and SEC Staff Accounting Bulletin No. 98 ("SAB 98"). Under
the provisions of SFAS No. 128 and SAB 98, basic net income (loss) per share is
computed by dividing the net income (loss) available to shareholders for the
period by the weighted average number of common shares outstanding during the
period. Diluted net income (loss) available per share is computed by income
(loss) available to common shareholders for the period by the weighted average
number of common and dilutive common equivalent shares outstanding during the
period. The Company has presented historical basic and diluted net loss per
share in accordance with SFAS No. 128. As the Company had a net loss in each of
the periods presented, basic and diluted net loss per share is the same.

3.   Recent Accounting Pronouncements

     On December 3, 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial
Statements", which provides guidance on the recognition, presentation and
disclosure of revenue in financial statements.  The SAB is effective for the
first quarter of the fiscal year beginning after December 15, 1999, which will
be the Company's first quarter of fiscal 2001.  The Company has not evaluated
the impact of this SAB on its financial reporting or results of operations.
However the Company believes that adoption of SAB 101 will have a material
impact on revenues during the first several quarters after adoption.

                                       5
<PAGE>

                            Data Return Corporation
                    Notes to Condensed Financial Statements
                             Unaudited (Continued)

4.   Property and Equipment

     Property and equipment consists of the following:

                                              December 31, 1999  March 31, 1999
                                              -----------------  --------------
     Electronics and computer equipment          $ 2,905,000       $ 853,000
     Computer software                             1,180,000          39,000
     Furniture and office equipment                  412,000          15,000
     Leasehold improvements                          181,000          11,000
     Capital leases--equipment                     6,013,000          51,000
     Other                                           155,000              --
                                                 -----------       ---------
                                                  10,846,000         969,000
     Less accumulated depreciation and
        amortization                                (970,000)       (143,000)
                                                 -----------       ---------
                                                 $ 9,876,000       $ 826,000
                                                 ===========       =========

Compaq Lease Agreement

     The Company entered into a Master Lease Agreement with Compaq Financial
Services Corporation.  As of December 31, 1999, the Company has acquired $6.0
million in computer equipment under the capital lease agreement.

5.   Accrued Expenses

     Accrued expenses consist of the following:

                                              December 31, 1999  March 31, 1999
                                              -----------------  --------------
     Professional fees                           $   112,000       $      --
     Accrued compensation                            834,000         104,000
     Interest                                         61,000              --
     Other                                           278,000          29,000
                                                 -----------       ---------
                                                 $ 1,285,000       $ 133,000
                                                 ===========       =========

6.   Shareholders' Equity

Initial Public Offering

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

Issuance of Common Stock

     During the nine-month period ending December 31, 1999, the Company issued
5,251,418 shares of common stock to private investors for net proceeds of $13.9
million, including a $3.0 million investment by Compaq Computer Corporation and
a $5.0 million investment by Microsoft Corporation.

Microsoft Agreements

     On September 3, 1999, the Company entered into a five-year Development,
License and Co-Marketing Agreement with Microsoft Corporation. Under the
agreement, the Company will deliver initial proprietary installation tools for
three specific applications that are used on Microsoft NT.  Modifications to the
tools will be cross-licensed between Data Return and Microsoft.  The Company
will also train Microsoft's employees and customers in the use of the tools.
Microsoft has the sole right to terminate the agreement if the Company fails to

                                       6
<PAGE>

                            Data Return Corporation
                    Notes to Condensed Financial Statements
                             Unaudited (Continued)

deliver the tools on a timely basis or if the Company fails to correct any
errors in the tools on a timely basis. Also as part of the agreement, Microsoft
will provide up to one hundred hours of technical consulting and writing
services during the development of the tools.  Microsoft has the right to review
certain installation tools that the Company may develop over the next five years
and to receive a percentage of any revenues earned from the licensing or
exploitation of those tools.

     In connection with the agreement, Microsoft acquired an immediately
exercisable five-year warrant to acquire an additional 340,910 shares of the
Company's common stock for $11 per share. The Company recorded the deferred
product development costs as contra equity in the amount of $2.1 million, which
is the value of the warrant as estimated using a Black Scholes pricing model.
The asset will be amortized to expense over the lesser of the expected period of
benefit or the five-year term of the agreement. The Company will periodically
evaluate the recoverability of the asset over the five-year term of the
agreement.


Level 3 Agreements

     The Company entered into a Strategic Marketing and Sales Agreement with
Level 3 on July 1, 1999. The Strategic Marketing and Sales Agreement provides
that the Company will acquire from Level 3, for a five year period commencing
with the date of the agreement, most of its requirements for co-location space,
technical assistance, broadband service and private line service (collectively
the "Services") to the extent that the Services are substantially similar or
perform substantially the same function as the Services available from other
providers. The prices the Company will pay Level 3 for the Services over the
term of the Agreement are based upon Level 3's then-current prices to other
companies purchasing similar quantities. The Agreement also provides for joint
sales and marketing efforts between the Company and Level 3, including cross
training of personnel, and provides that Level 3 will designate the Company as a
preferred provider for Advanced Microsoft Hosting Service. The Company will pay
commissions to Level 3 personnel for new customers generated by their leads.

     The Company's annual commitment for the Services is as follows for its year
ended March 31:

          2000          $   400,000
          2001            1,000,000
          2002            1,400,000
          2003            2,000,000
          2004            3,200,000
          2005            2,000,000
                        -----------
                        $10,000,000
                        ===========

     Payments for the minimum annual purchase commitments will be required
regardless of whether the Company uses the Services. The Company can apply the
$5.0 million credit described below beginning on January 1, 2001 to purchases in
excess of the minimum annual commitments required by the Strategic Marketing and
Sales Agreement. Pricing of the Services will be based on Level 3's established
market prices at the time the service is provided.

     On July 26, 1999, Level 3 Communications, Inc. ("Level 3") acquired
1,952,940 shares of the Company's common stock in exchange for a $5.0 million
credit to be applied to the purchase of future broadband services.  The Company
has recorded the deferred broadband services acquired in the agreement as a
contra equity account which will be amortized to cost of revenue as the
broadband services are used and paid for with the credit. The credit can be
applied as payment for services in excess of the minimum purchases required
under the Strategic Marketing and Sales Agreement (see above) beginning on
January 1, 2001.  The Company has a limited right to reacquire the stock in the
event that Level 3 fails to fulfill its obligations under the Service Credit
Agreement or fails to deliver the broadband services pursuant to the terms of
the Service Credit Agreement.  The number of shares subject to the Company's
right to reacquire the stock will be reduced pro rata in each quarter of
calendar year 2001 by the greater of the credit applied to future purchases of
bandwidth or 25% of the total shares.  The stock can be reacquired by the
Company at the original purchase price by the Company's forgiveness of the
remaining balance of the credit.  In the event the Company's right to reacquire
the stock is exercised, Level 3 is required to pay the Company $750,000, reduced
ratably, based on the amount of bandwidth credit used by the Company.

                                       7
<PAGE>

                            Data Return Corporation
                    Notes to Condensed Financial Statements
                             Unaudited (Continued)

ASP and Server Agreement

     In connection with the equity investment by Compaq, the Company entered
into an agreement with Compaq to purchase the lesser of 2,000 servers or the
number of servers reasonably necessary to operate the Company's business.  The
requirement to purchase the servers is contingent upon Compaq providing
financing for the servers on competitive terms, upon the price, performance and
quality of the servers being reasonably satisfactory to the Company and upon
Compaq's commitment to deliver these servers on the schedule the Company
requests.


Stock Options

     Certain employees of the Company were granted options pursuant to the
Company's 1998 Stock Option Plan and an employment agreement to purchase
5,729,900 shares of the Company's common stock at less than fair value.  The
Company recorded deferred stock compensation of $874,000 for the nine-month
period ended December 31,1999 for the difference between the exercise price and
the deemed fair value of the Company's common stock underlying certain option
grants.  Upon the initial public offering, vesting on 4,700,775 of these options
accelerated to the effective date of the prospectus filed by the Company.  In
connection with the acceleration of vesting, the Company recorded an additional
charge of approximately $1.2 million in the third quarter related to the stock
based compensation. The deferred stock compensation is being amortized over the
vesting period of the individual options, generally four years. The stock
compensation expense charged to income amounted to $1,527,000 and $257,000 for
the nine-month periods ended December 31, 1999 and 1998, respectively.

     In July 1999, the Company adopted the 1999 Long-Term Incentive Plan.  The
Plan provides for the issuance of up to 3,228,000 options to acquire its common
stock.


Stock Split

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


Shareholder Rights Plan

     On September 27, 1999, the Board of Directors adopted a Shareholder Rights
Plan (the "Plan") and declared a dividend of one preferred stock purchase right
for each share of common stock. Each right entitles its registered holder to
purchase one one-hundredth of a share of newly designated series A junior
participating preferred stock at a purchase price of $100.00. The rights are
attached to and trade with shares of the Company's common stock, including
future issuances of common stock. The rights are not currently exercisable and
become exercisable upon the earlier to occur of (a) the public announcement that
a person or group of persons has acquired 15% or more of the Company's common
stock, except in connection with an offer approved by the Board of Directors, or
(b) the close of business on the tenth business day, or a later date determined
by the Board of Directors, after the commencement of, or announcement of an
intention to commence, a tender or exchange offer that would result in a person
or group of persons acquiring 15% or more of the Company's common stock. In the
event the rights become exercisable, each holder of a right (except the
Acquiring Person, as defined by the Plan) will have the right to receive shares
of the Company's common stock having a market value of two times the exercise
price of the right. Also, if the Company is acquired in a merger in which the
Company is not the surviving corporation, or there is a sale of 50% or more of
the Company's assets or earning power, each holder of a right may receive common
stock of the acquiring company having a market value equal to two times the
exercise price of the right. The rights expire September 27, 2009. Each share of
series A junior participating preferred stock has dividend, liquidation and
voting rights equal to those of 100 shares of the Company's common stock. The
series A junior participating preferred stock is not redeemable.

                                       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.  This discussion contains, in addition to historical information,
forward-looking statements that involve risks and uncertainties. Our actual
results could differ materially from the results discussed in the forward-
looking statements.  Factors that could cause or contribute to such differences
include, but are not limited to, those discussed below, as well as those
discussed below under "Factors Affecting Future Operating Results."  We disclaim
any obligation to update information contained in any forward-looking statement.
See "Forward-Looking Statements."

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 is 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, are not meaningful and should not be relied upon
as indicators of future performance.  We do not believe that our historical
growth rates are indicative of future results.

     Currently, we derive substantially all of our revenues from advanced
hosting services.  We also derive a nominal amount of revenue from technical
reviews and the resale of software and other products.  Currently, most of our
advanced hosting revenues are generated from recurring monthly fees.  The
remainder are derived from one-time set-up fees for installation. Revenues are
billed on a monthly basis and are recognized as the service is performed.  Most
of our customer agreements may be canceled on 30 days' notice.

  Our expenses are comprised of:

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

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

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

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

  We have incurred significant losses since our inception and, as of December
31, 1999, had an accumulated deficit of approximately $8.1 million.  We intend
to invest heavily in marketing and sales and the continued development of our
network infrastructure and technology.  We expect to expand our operations and
workforce, including our network operations, technical support, sales, marketing
and administrative resources.  In particular, we intend to expand our existing
inside and outside sales force to develop new sales channels and relationships.
We expect to continue to incur substantial losses for the foreseeable future.
We may not be able to successfully execute our expansion plans.

                                       9
<PAGE>

Results of Operations

Comparison of three-month periods ended December 31, 1999 and 1998

Revenues

     Our revenues increased $2,947,000 to $3,414,000 for the three-month period
ended December 31, 1999 from $467,000 for the three-month period ended December
31, 1998.  The increase was primarily due to the addition of new customers that
generated higher average monthly revenues, as well as from organic growth from
certain existing customer accounts.  We increased our marketing and sales
personnel to 40 at December 31, 1999 from five at December 31, 1998.

Cost of revenue

     Our cost of revenue increased $2,810,000 to $3,090,000, or 90.5% of
revenue, during the three-month period ended December 31, 1999 from $280,000, or
59.9% of revenue, during the three-month period ended December 31, 1998.  The
increase in cost of revenue over the two periods was due primarily to increases
in personnel and related costs, including employee recruiting fees,
depreciation, and bandwidth. Personnel and related expenses increased
approximately $1,652,000 to $1,788,000, or 57.9% of cost of revenue, for the
three-month period ended December 31, 1999 from $136,000 for the three-month
period ended December 31, 1998, as we increased our systems and customer support
personnel to 149 at December 31, 1999 from eleven at December 31, 1998.
Depreciation expense increased approximately $495,000 to $519,000 for the three-
month period ended December 31, 1999 as we have added approximately $10.3
million in computer and related equipment since December 31, 1998.  Our
broadband services expenses increased $325,000 to approximately $413,000 for the
three-month period ended December 31, 1999 from $88,000 for the three-month
period ended December 31, 1998, to support our increased business activities.
The increase in cost of revenues as a percentage of total revenues is largely
the result of the Company's investment in personnel and infrastructure to
accommodate future growth. We expect our cost of revenue to continue to increase
in conjunction with the growth of our overall business.

General and administrative

     General and administrative expense increased $1,844,000, to $2,087,000, or
61.1% of revenue, during the three-month period ended December 31, 1999 from
$243,000, or 52.0% of revenue, for the three-month period ended December 31,
1998.  The increase is primarily due to increases in personnel and related
expenses, including employee recruiting fees, travel, and professional services.
Personnel and related expenses increased $1,078,000 to $1,216,000, or 58.3% of
general and administrative expenses, for the three-month period ended December
31, 1999 from $139,000 for the three-month period ended December 31, 1998.  We
increased our number of employees in general and administrative functions to 40
employees at December 31, 1999 from five employees at December 31, 1998.  Travel
expenses increased approximately $206,000 to $215,000 for the three-month period
ended December 31, 1999 from $9,000 in the comparable period in 1998.
Professional services fees increased approximately $105,000 to $109,000 for the
three-month period ended December 31, 1999 from $4,000 in the comparable period
in 1998.

Marketing and sales

     Marketing and sales expense increased $1,691,000 to $1,854,000 or 54.3% of
revenue, during the three-month period ended December 31, 1999 from $163,000 or
34.9% of revenue, during the three-month period ended December 31, 1998.  The
increase was due primarily to an increase in marketing and sales personnel and
related expenses, including employee recruiting fees, and advertising costs.
Personnel and related expenses increased $1,459,000 to $1,544,000, or 83.3% of
marketing and sales expense, from $85,000 for the three-month period ended
December 31, 1998.  Advertising costs increased $68,000 to $141,000 for the
three-month period ended December 31, 1999 from $72,000 for the three-month
period ended December 31, 1998.  We increased our marketing and sales personnel
to 40 at December 31, 1999 from five at December 31, 1998.  We expect our
marketing and sales expenditures to continue to increase during the remainder of
fiscal 2000.

                                       10
<PAGE>

Stock based compensation

     Deferred stock compensation was recorded in connection with the grant of
employee stock options below fair value. Amortization of stock based
compensation totaled $1,230,000 for the three-month period ended December 31,
1999 and $86,000 for the three-month period ended December 31, 1998. The
amortization of stock based compensation is based on the vesting schedule of
stock options held by our employees. Upon the initial public offering, vesting
on 4,700,775 of these options accelerated to the effective date of the
prospectus resulting in an additional charge of approximately $1.2 million.

Other income (expense)

     Other income (expense) consists primarily of interest income on our cash
balances and interest expense on our outstanding notes payable and capital lease
obligations.  Interest earned on our cash and cash equivalents increased
$889,000 to $892,000 for the three-month period ended December 31, 1999 from
$3,000 for the three-month period ended December 31, 1998.  This increase was
due primarily to the closing of our initial public offering, which resulted in
larger cash balances available for investment.  During the three-month periods
ended December 31, 1999 and 1998, we incurred interest expense in the amount of
$78,000 and $4,000, respectively.

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 reserve
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.

Net Loss

     Net loss increased $3,727,000 to $4,033,000 for the three-month period
ended December 31, 1999 from $306,000 for the three-month period ended December
31, 1998.  As more fully discussed above, the increased net loss is primarily
attributable to increased costs related to the overall growth of our business.

EBITDA

     EBITDA, as defined below, decreased $2,791,000 to negative $2,974,000 for
the three-month period ended December 31, 1999 from negative $184,000 for the
three-month period ended December 31, 1998. The decrease is primarily
attributable to costs associated with our growth strategy. We expect to generate
negative EBITDA in the  fourth quarter of our fiscal year 2000. Costs associated
with our investments in marketing and sales, the continued development of our
network infrastructure and technology and expansions of our operations and
workforce, including our network operations, technical support, sales, marketing
and administrative resources, will continue to represent a large portion of our
expenses during our planned expansion.

     EBITDA consists of loss from operations before depreciation and
amortization, including amortization of unearned stock based compensation.
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 other
companies. 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.

                                       11
<PAGE>

Comparison of nine-month periods ended December 31, 1999 and 1998

Revenues

     Our revenues increased $5,253,000 to $6,367,000 for the nine-month period
ended December 31, 1999 from $1,114,000 for the nine-month period ended December
31, 1998. The increase was primarily due to the addition of new customers that
generated higher average monthly revenues, as well as from organic growth from
certain existing customer accounts. We increased our marketing and sales
personnel to 40 at December 31, 1999 from five at December 31, 1998.

Cost of revenue

     Our cost of revenue increased $4,133,000 to 4,861,000, or 76.4% of revenue,
during the nine-month period ended December 31, 1999 from $728,000, or 65.3% of
revenue, during the nine-month period ended December 31, 1998. The increase in
cost of revenue over the two periods was due primarily to increases in personnel
and related expenses, including employee recruiting fees, contract personnel,
depreciation, and bandwidth.  Personnel and related expenses increased
approximately $2,297,000 to $2,647,000, or 54.4% of cost of revenue, for the
nine-month period ended December 31, 1999 from $350,000 for the nine-month
period ended December 31, 1998, as we increased our systems and customer support
personnel to 149 at December 31, 1999 from eleven at December 31, 1998.
Depreciation expense increased approximately $686,000 to $733,000 for the nine-
month period ended December 31, 1999 as we added approximately $10.3 million in
computer and related equipment since December 31, 1998. Our broadband services
expenses increased $548,000 to approximately $789,000 for the nine-month period
ended December 31, 1999 from $241,000 for the nine-month period ended December
31, 1998, to support our increased business activities.  The increase in cost of
revenues as a percentage of total revenues is largely the result of the
Company's investment in personnel and infrastructure to accommodate future
growth. We expect our overall cost of revenue to continue to increase in
conjunction with the growth of our overall business.

General and administrative

     General and administrative expense increased $3,509,000 to $4,177,000, or
65.6% of revenue, during the nine-month period ended December 31, 1999 from
$667,000, or 59.9% of revenue, for the nine-month period ended December 31,
1998. The increase is primarily due to increases in personnel and related
expenses, including employee recruiting fees, travel expenses, and professional
services expenses. Personnel and related expenses increased $2,088,000 to
$2,445,000, or 58.6% of general and administrative expenses, for the nine-month
period ended December 31, 1999 from $357,000 for the nine-month period ended
December 31, 1998. We increased our number of employees in general and
administrative functions to 40 employees at December 31, 1999 from five
employees at December 31, 1998.  Travel expenses increased approximately
$296,000 to $324,000 for the nine-month period ended December 31, 1999 from
$28,000 in the comparable period in 1998.  Professional services fees increased
approximately $228,000 to $237,000 for the nine-month period ended December 31,
1999 from $9,000 in the comparable period in 1998.

Marketing and sales

     Marketing and sales expense increased $2,873,000 to $3,306,000, or 51.9% of
revenue, during the nine-month period ended December 31, 1999 from $433,000, or
38.9% of revenue, during the nine-month period ended December 31, 1998. The
increase was due primarily to an increase in marketing and sales personnel and
related expenses, including employee recruiting fees, and advertising costs.
Personnel and related expenses increased $2,318,000 to $2,534,000, or 76.7% of
marketing and sales expense, from $216,000 for the nine-month period ended
December 31, 1998.  Advertising costs increased $337,000 to $538,000 for the
nine-month period ended December 31, 1999 from $201,000 for the nine-month
period ended December 31, 1998. We increased our marketing and sales personnel
to 40 at December 31, 1999 from five at December 31, 1998. We expect our
marketing and sales expenditures to continue to increase during the remainder of
fiscal 2000.

                                       12
<PAGE>

Stock based compensation

     Deferred stock compensation was recorded in connection with the grant of
employee stock options below fair value. Amortization of stock based
compensation totaled $1,527,000 for the nine-month period ended December 31,
1999 and $257,000 for the nine-month period ended December 31, 1998. The
amortization of stock based compensation is based on the vesting schedule of
stock options held by our employees. Upon the initial public offering, vesting
on 4,700,775 of these options accelerated to the effective date of the
prospectus resulting in an additional charge of approximately $1.2 million. We
recorded additional deferred stock compensation of $874,000 during the nine-
month period ended December 31, 1999.

Other income (expense)

     Other income (expense) consists primarily of interest income on our cash
balances and interest expense on our outstanding notes payable and capital lease
obligations. Interest earned on our cash and cash equivalents increased $989,000
to $1,003,000 for the nine-month period ended December 31, 1999 from $14,000 for
the nine-month period ended December 31, 1998. This increase was due primarily
to the closing of private placements of equity securities during the first three
quarters of fiscal 2000, and the closing of the initial public offering during
the third quarter, which resulted in larger cash balances available for
investment. During the nine-month period ended December 31, 1999 and 1998, we
incurred interest expense in the amount of $90,000 and $8,000 respectively.

Income taxes

     No provision for federal income taxes has been recorded as we have incurred
net operating losses since inception. We have recorded a valuation reserve
against all of the 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.

Net Loss

     Net loss increased $5,625,000 to $6,590,000 for the nine month period ended
December 31, 1999 from $965,000 for the nine month period ended December 31,
1998. As more fully discussed above, the increased net loss is primarily
attributable to increased costs related to the overall growth of our business.

EBITDA

     EBITDA, as defined below, decreased $4,427,000 to negative $5,064,000 for
the nine-month period ended December 31, 1999 from negative $637,000 for the
nine-month period ended December 31, 1998. The decrease is primarily
attributable to costs associated with our growth strategy. We expect to generate
negative EBITDA in the fourth quarter of fiscal 2000. Costs associated with our
investments in marketing and sales, the continued development of our network
infrastructure and technology and expansions of our operations and workforce,
including our network operations, technical support, sales, marketing and
administrative resources, will continue to represent a large portion of our
expenses as we attempt to grow our business.

     EBITDA consists of loss from operations plus depreciation and amortization,
including amortization of unearned stock based compensation. 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 other companies. 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.

                                       13
<PAGE>

Liquidity and Capital Resources

     We have historically financed our operations primarily through sales of
equity securities. Our cash balances increased by approximately $91.9 million
during the nine months ended December 31, 1999 to $92.8 million. This net change
is primarily a result of net proceeds of $85.9 million from our initial public
offering, which consisted of the sale of 7,187,500 shares of our common stock
including the underwriters' over allotment. In addition, we issued 5,706,000
shares of common stock in private placements for net proceeds of $13.9 million,
including a $3 million investment by Compaq and a $5.0 million investment by
Microsoft. Additionally, we issued Microsoft an immediately exercisable five
year warrant to acquire 340,910 shares of our common stock at $11.00 per share
for no additional cash consideration. We recorded deferred product development
costs of approximately $2.1 million related to the value of the warrant, which
will be amortized to expense over the lesser of the expected period of benefit
or the five-year term of the agreement.

     The increase in cash was partially offset by our investment in property and
equipment of approximately $9.8 million during the nine-month period ended
December 31, 1999. We have acquired approximately $6.0 million of the new
equipment from Compaq under a Master Lease Agreement. Our investment in property
and equipment consisted primarily of installation of network infrastructure
equipment and purchases of furniture and equipment for new employees.

     Total borrowings under our notes payable and capital lease obligations as
of December 31, 1999 were approximately $6.8 million.  Notes payable totaling
$183,000 were repaid with a portion of the proceeds of the initial public
offering.

     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, 2000 and
outstanding balances accrue interest at the bank's base rate. We may borrow up
to $2 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.

     We believe that our current cash balances will be sufficient to meet our
working capital and capital expenditure requirements for at least the next 12
months. Under our agreement with Level 3, we are required to purchase at least
$10.0 million of bandwidth and co-location services over the next five years.
Our quarterly commitment is $200,000 in the first year, $300,000 in the second
year, $400,000 in the third year, $600,000 in the fourth year and $1.0 million
in the fifth year of the agreement. We anticipate that further expansion of our
operations will cause us to incur negative cash flows on a short-term basis, and
therefore require us to use our cash and other liquid resources to support our
growth. Our operating and investing activities on a long-term basis may require
us to obtain additional equity or debt financing. We have no present
understandings, commitments or agreements with respect to any acquisition of
other businesses, products, services or technologies. However, we may evaluate
potential acquisitions of other businesses, products and technologies from time
to time. In order to consummate potential acquisitions, we may need additional
equity or debt financings in the future.

The Year 2000

Impact of the Year 2000

     Currently, many computer and software products are coded to accept two-
digit entries in the date code field. These date code fields will need to accept
four-digit entries to distinguish 21st century dates from 20th century dates. As
a result, many companies' software and computer systems will need to be upgraded
or replaced to comply with Year 2000 requirements. Failure to make such upgrades
or replacements could result in system failure or erroneous calculations,
causing disruptions of operations, such as an inability to process transactions,
send invoices and engage in other normal business activities. We recognize the
need to ensure that our operations are not adversely impacted by Year 2000
software and computer system failures. We are not currently aware of any Year
2000 compliance problems relating to our computer systems that would have a
significant negative effect on our business, operating results or financial
condition.


                                       14
<PAGE>

Costs

     To date we have not incurred any material expenditures in connection with
identifying or evaluating Year 2000 compliance issues. We continue to collect
information and make the necessary revisions to our systems in an ongoing effort
to maintain Year 2000 compliance. We are not aware of any critical third-party
software application which requires replacement. In the event we are required to
make such a replacement, we do not anticipate that such expenses will be
substantial. However, such expenses, if higher than anticipated, could harm our
business and operating results.

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
"may," "will," "expect," "intend," "anticipate," "estimate" and similar words,
or by discussions of strategy that involve risks and uncertainties, although
some forward-looking statements are expressed differently.  You should be aware
that our actual results could differ materially from those contained in the
forward-looking statements due to a number of factors, including without
limitation, changes in external competitive market factors, changes in our
business strategy or an inability to execute our strategy, changes in the
hosting industry, the economy in general and changes in the use of the Internet.
We cannot guarantee future results, levels of activity, performance or
achievements.  Our actual results could differ materially from those anticipated
in such forward-looking statements as a result of certain factors, including
those set forth in the section entitled "Factors Affecting Future Operating
Results."  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 "Factors Affecting Future Operating Results" 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.

Factors Affecting Future Operating Results

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

     We were incorporated in August 1997 and commenced operations in September
of that year with a focus on advanced hosting services.  As a result, we have a
limited operating history and our business model is evolving.  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.

We have a history of substantial losses, and we anticipate continuing and
increasing 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 $4.0 million, or negative 118.2% of
revenues, for the three-month period ended December 31, 1999, and $1.3 million,
or negative 68% of revenues, for the year ended March 31, 1999.  As of December
31, 1999, we had an accumulated deficit of approximately $8.1 million.  We
expect our operating expenses to increase significantly as we attempt to expand
our business.  We believe that we will need to hire significant numbers of
additional personnel in all areas of our business over the next 12 months.  We
are also required to purchase $800,000 dollars of co-location and bandwidth
services from Level 3 during the first year of our agreement with them.  In
addition, we expect to incur significant expenses to develop our distribution
channel, fund greater levels of research and development, support and improve
our operational and financial systems and broaden customer service and support.
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.

                                       15
<PAGE>

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
continue 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:

  .  size and timing of customer installations and related payments;

  .  fluctuations in data and voice communications costs;

  .  timing and magnitude of capital expenditures;

  .  costs relating to the expansion of operations;

  .  customer discounts and credits;

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

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

     We plan to increase our operating expenses to develop our business. If our
revenues do not increase as quickly as our expenses, our operating results will
suffer.

     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.

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

     We recently 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 co-location,
Internet connectivity and other services. Our ability to increase demand for our
services depends in part upon Level 3's referrals of new customers to us. This
relationship is non-exclusive, and our marketing agreement can be terminated by
Level 3 if we default on our obligations under this agreement or are acquired by
a competitor of Level 3. If Level 3 fails to refer new customers to us or refers
potential customers to our competitors or if our relationship with Level 3
deteriorates or is terminated for any reason, we may not be able to increase our
customer base and, therefore, our revenues as rapidly as we anticipate and our
business would suffer. If we fail to train Level 3's sales personnel, or fail to
train them adequately, we will not realize some of the benefits that we believe
we will receive under this arrangement, including customer referrals. As part of
our relationship, we have committed to purchase a fixed amount of services from
Level 3, including, among other things, bandwidth, co-location space,
installation and maintenance services, over the next five years. We will incur
these expenses even if anticipated increases in sales do not materialize or, in
some circumstances, if the agreement is terminated. We have also agreed that if
Level 3 is capable of providing the services we request, and if we determine
that those services meet our then-current performance criteria, we will purchase
75% of these services from Level 3 from July 2000 through December 2000 and 90%
of these services from Level 3 from January 2001 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.

                                       16
<PAGE>

     Our relationship with Level 3 also entitles us to offer our services from
all existing and future U.S. Level 3 data centers. We currently rely on Level 3
to provide all of the data center capacity that we need to provide our hosting
services, and in the future we will be required to purchase most of our data
center capacity from Level 3. Further, Level 3 will 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 perform these services
in a timely or effective manner, or at all, we would be required to make
alternate arrangements, possibly including hiring additional implementation
engineers. In addition, if our relationship with Level 3 is terminated or if
Level 3 does not provide the data center capacity that we need, 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
bandwidth and other networking services. If we are unable 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. Our relationship with
Microsoft is 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 or designations. We do not have a written
agreement with Microsoft relating to these certifications or designations. Some
of our competitors also have received these certifications and designations.
Microsoft confers these certifications unilaterally and in its sole discretion
and could change them at any time. Thus, we cannot be certain that we will
continue to enjoy them.

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

     We must continue to expand and adapt our network infrastructure to
accommodate the increasing number of customers, the amount of information they
wish to transmit and their changing requirements. We face risks related to our
network's ability to be scaled to meet increasing customer levels while
maintaining acceptable performance levels. The expansion and adaptation of our
networking and hosting facility infrastructure will 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. Due to the limited deployment of our services to date, the
ability of our network to support a substantially larger number of customers at
high transmission speeds is unknown.  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.

     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 numerous network
providers, some of which are also our competitors. In the future, we will be
required to purchase most of our network capacity from Level 3 to the extent
they meet our then-current performance and capacity requirements. We depend on
these companies to provide uninterrupted and error-free service through their
telecommunications networks. As 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 capacity is not available to us as our customers' usage increases,
our network may not be
                                       17
<PAGE>

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.

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 have agreed for the next
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 December 31, 1999, we have purchased approximately
600 servers from Compaq. 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 either 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. 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 are highly uncertain. Businesses may not be aware
of the potential benefits of outsourcing or may find it cheaper, 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. If the market for advanced hosting services fails to grow
or grows more slowly than we anticipate, our business, operating results and
financial condition will be adversely affected. Growth in the demand for our
products and services may be inhibited, and we may be unable to sustain growth
in our customer base, for a number of reasons, including:

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

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

  .  the termination of our customer contracts, which can generally be canceled
     on 30 days' notice;

  .  our inability to strengthen awareness of our brand; and

  .  reliability, quality or compatibility problems with our services.

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

     Our market is characterized by rapidly changing technology, evolving
industry standards and frequent new product announcements.  These
characteristics are magnified by the recent 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.
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

                                       18
<PAGE>

adapt to these changes. 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 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 recently begun to
increase rapidly. Our success depends in large part on continued growth in the
use of the Internet.  In addition, our business plan anticipates extensive
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;

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

  .  inconsistent quality of service;

  .  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.

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

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

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

  We are currently experiencing rapid growth and intend to continue expanding.
Since incorporating in August 1997, we had grown from five to 229 employees as
of December 31, 1999.  We believe that we will need to hire significant numbers
of additional personnel in all areas of our business over the next 12 months. If
we do not succeed in attracting and retaining new, qualified personnel and/or
retaining our current personnel, our business could suffer.

                                       19
<PAGE>

  We must expand our direct and indirect sales operations to increase market
awareness of our products and generate increased revenues. We cannot be certain
that we will be successful in these efforts. We plan to increase our sales force
significantly in the calendar 2000.  Newly-hired employees will require training
and it will take time for them to achieve full productivity. Also, through our
relationship with Level 3, we will begin training their sales force to sell our
products and services. We cannot be certain that we will be able to hire enough
qualified individuals in the future, that newly-hired employees will achieve
necessary levels of productivity or that our Level 3 relationship will result in
increased sales.

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

  We believe that our existing capital resources will enable us to maintain our
current and planned operations for at least the next 12 months. However, we may
require additional funds during or after that 12-month period. Any required
financing may not be available or may be available only on terms that are not
favorable to us. 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.

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

  To succeed, we must be able to operate our network management infrastructure
around the clock 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, sabotage, intentional acts of vandalism and similar
events. Our servers and network infrastructure are located primarily in the
Dallas/Ft. Worth, Texas metropolitan area. Even though we have attempted to
minimize risk through redundant systems, we do not have a comprehensive disaster
recovery plan and the occurrence of a natural disaster or other unanticipated
problems at any of our data centers 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 of our customers. Any future interruptions
     could:

  .  cause customers or end users to seek damages 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.

  We also often provide our customers with service level agreements. If we do
not meet the required service levels, we may have to provide credits to our
customers, which could significantly reduce our revenues. Additionally, in the
event of any resulting harm to customers, we could be held liable for damages.
Awards for such damages might exceed our liability insurance by an unknown but
significant amount and could seriously harm our business.

                                       20
<PAGE>

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. Although we have
not experienced any material software defects to date, it is possible that
defects may occur in the software. These defects could cause service
interruptions, 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.

     Despite our design and implementation of a variety of network security
measures, unauthorized access, computer viruses, 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 rely on third-party suppliers such as Level 3 to protect
our equipment and hardware against breaches in security. We cannot be certain
that they will provide adequate security. While we have experienced no material
security breaches in the past, any breaches that may occur could result in
liability to us, loss of existing customers or the deterrence of future
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
our standard terms and conditions 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. We also believe we would have meritorious defenses to
any such claims, but 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 by unknown but significant amounts, which would
seriously harm our business.

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

     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 service 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
some contractual arrangements with our employees and contractors as well as
suppliers, distributors and some of our key 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
                                       21
<PAGE>

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.

We could lose revenues and our reputation may be damaged if our systems or those
of our customers or our suppliers are not Year 2000 compliant.

     Many installed computer systems and software products required upgrades in
order for 21st century dates to be distinguished from 20th century dates.
Systems that do not comply with these "Year 2000" requirements may cause
miscalculations which will interfere with business activities or simply fail to
work. Although we implemented a Year 2000 program intended to ensure our
computer systems and applications function properly beyond 1999 and requested
assurances from our suppliers that their products are Year 2000 compliant and
have not experienced any significant Year 2000 issues to date, we cannot be sure
that we will be able to promptly or correctly address all relevant Year 2000
issues, especially where third-party customers or suppliers are involved. If we
cannot achieve Year 2000 compliance, our systems could be disrupted for a period
of time. This would cause a loss of revenues, including requests from customers
for credits for downtime. More importantly, any significant disruption would
seriously damage our business reputation. We might also face lawsuits for
damages. As of the date hereof we have not experienced any material Year 2000
problems, either in our systems or in the systems of our suppliers or customers.

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

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

The loss of key personnel including our Chairman and Chief Executive Officer or
our President and 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, and Michelle R. Chambers, our President and Chief Operating
Officer. We have entered into employment agreements with Mr. Vanderbeck and Ms.
Chambers expiring in 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.

We operate in an extremely competitive market, and our business would suffer if
we are unable to complete 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 of our competitors have
substantially greater financial, technical and marketing resources, larger
customer bases, longer operating histories, greater name recognition and more
established relationships in the industry than we do. As a result, some of these
competitors may be able to:

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

                                       22
<PAGE>

  .  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. We believe that the market in
which we compete is likely to experience consolidation in the near future, which
could result in increased competition on price and other factors that could
adversely affect our business.

     In an effort to gain market share, some of our competitors have 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.

Because we have international customers, our business may be adversely affected
by foreign political and economic conditions.

     In fiscal 1999, approximately 8% of our revenues were derived from our
customers located in Europe and Asia. In addition, we are beginning to operate
in London, England. Our success depends in part on expanding our customer base
internationally and our ability to successfully operate from data centers in
foreign markets. Because our international sales are denominated in U.S.
dollars, currency fluctuations may deter foreign customers from purchasing our
services. In addition, we face risks in operating and servicing customers in
foreign markets, such as:

  .  different Internet access fees;

  .  different technology standards;

  .  different privacy, censorship and service provider liability standards and
     regulations

  .  less protective intellectual property laws.

Any of these risks could adversely affect our ability to operate or expand
internationally, which would limit the growth of our business.

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 intend generally to use  the net proceeds from our 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 the actual
expected expenditures and thus cannot estimate the amounts to be used for each
specified purpose. Our management will have 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.


                                       23
<PAGE>

Our principal shareholders, directors and executive officers currently own
approximately 76% 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 76% 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 us 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 classified board of directors with staggered three-year
     terms.

  We are also subject to certain provisions of Texas law which 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.

  Currently, 35,398,004 shares of our common stock are issued and outstanding.
All 7,187,500 shares of our common stock sold in our initial public offering are
freely tradable unless purchased by our "affiliates." In connection with this
offering, our officers, directors and shareholders not purchasing in the
offering who together own approximately 28,210,504 shares of our common stock
agreed to refrain from selling any shares of our common stock until April 25,
2000. However, these restrictions may be waived in some circumstances. 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 after this offering 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.
There are 35,398,004 shares currently outstanding, of which 30,489,100 shares
will become available for sale to the public on April 25, 2000, subject in some
cases to volume limitations.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.

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

                                       24
<PAGE>

          PART II - OTHER INFORMATION

Item 2  Changes in Securities and Use of Proceeds.

(a)     Microsoft Private Placement

        On October 28, 1999 the Company issued 454,546 shares of Common Stock to
Microsoft for a purchase price of $5,000,000.  Additionally, an immediately
exercisable five-year warrant to acquire an additional 340,910 shares of Common
Stock was issued to Microsoft on the same date.  This sale was deemed to be
exempt from registration under the Securities Act in reliance on section 4(2) of
the Securities Act as transactions by an issuer not involving a public offering.

(b)     Initial Public Offering

        In late October and early November, we issued 7,187,500 shares of common
stock registered in connection with our initial public offering at a price of
$13.00 per share for gross proceeds to us of approximately $93.4 million  and
estimated net proceeds of approximately $85.9 million.

                                       25
<PAGE>

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

(a)     Exhibits:

        10.1 Credit Agreement dated December 29, 1999 between Data Return
             Corporation and Bank One, Texas, N.A.

        10.2 Promissory Note dated December 29, 1999 to Bank One, Texas, N.A.

        27   Financial Data Schedule (1).

(b)     Reports on Form 8-K:

        None

-------------------

(1)     Included with EDGAR version only.


                                  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: February 14, 2000          By:   /s/ Stuart A. Walker
                                     ----------------------------------------
                                     Stuart A. Walker, Vice President
                                     Chief Financial Officer
                                     (Principal Financial & Accounting Officer &
                                      Authorized Officer)

                                       26