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+RISK FACTORS An investment in our new common stock is extremely risky. You should carefully consider the following factors, together with the other information contained in this prospectus, before deciding to exercise your rights. An investment in our new common stock involves a high degree of risk and may not be appropriate for investors who cannot afford to lose their entire investment. RISK FACTORS RELATING TO OUR BUSINESS THE BANKRUPTCY MAY HAVE CREATED A NEGATIVE IMAGE OF US. The effect, if any, which our plan of reorganization may have on our operations now that it has been consummated cannot be accurately predicted or quantified. We believe that the consummation of our plan of reorganization will have a minimal future effect on our relationships with our customers, employees and suppliers. Our plan of reorganization was consummated on March 31, 2000, but there could be a detrimental impact on future sales and patronage because of the negative image of us that may have been created by the bankruptcy. OUR LEVEL OF DEBT MAY NOT ALLOW US PROPERLY TO PLAN FOR FUTURE OPPORTUNITIES OR TO COMPETE EFFECTIVELY. After the consummation of our plan of reorganization, we have a significant amount of indebtedness. Assuming the completion of the purchase of all shares of new common stock under the rights offering, our total consolidated indebtedness would be $169.5 million and the ratio of total consolidated indebtedness to total capitalization would be 48%. Our high level of indebtedness will have several important effects on our future operations, including: - requiring us to devote a substantial portion of our cash flow from operations to pay interest on our indebtedness and not for other uses, such as funding working capital or capital expenditures; - limiting our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, general corporate purposes or other purposes; - putting us at a competitive disadvantage to our competitors who have less debt than us; and - limiting our flexibility to plan for, or to react to, changes in our business and the industry in which we operate. Please refer to the sections of this prospectus called "The Plan of Reorganization -- The New Debt and Equity" and "Description of Existing Indebtedness" for a description of our new indebtedness after consummation of our plan of reorganization. LIQUIDITY CONSTRAINTS MAY HINDER OUR CONTINUED OIL AND GAS OPERATIONS. We have historically funded our operations primarily through our cash flow from operations and borrowings under credit sources. Due to our need to conserve capital, we have reduced maintenance of our wells, which has substantially reduced our cash flow from operations. We anticipate our principal sources of liquidity during the next 12 months will be cash on hand, including the net proceeds of the rights offering and the standby loan, and cash generated by operations. For more information regarding our liquidity constraints, see the sections of this prospectus called "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources," "Description of Existing Indebtedness" and our consolidated financial statements and the related notes included in this prospectus. Our ability to raise funds through additional indebtedness is limited by the terms of our plan of reorganization. Additionally, substantially all of our crude oil and natural gas properties are subject to a lien for the benefit of the lenders under the new credit facility, further limiting our ability to incur additional indebtedness. We may also choose to issue equity securities or sell assets to fund our operations, although the terms of our new indebtedness limit our use of the proceeds of any sale of assets. For a description of these limitations, see the sections of this prospectus called "The Plan of Reorganization -- The New Debt and Equity" and "Description of Existing Indebtedness." If we elect to raise additional capital by issuing equity securities, there can be no assurance that we will be able to obtain equity financing on satisfactory terms. PAST SUBSTANTIAL NET LOSSES MAY AFFECT FUTURE OPERATIONS. We experienced a substantial loss for the year ended December 31, 1998 of $203.3 million and for the year ended December 31, 1999 of $30.7 million. There can be no assurances that we will become profitable in the future. For more information regarding our losses, see the section of this prospectus called "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our consolidated financial statements and the related notes included in this prospectus. WE MAY NOT BE ABLE TO REPLACE DEPLETED RESERVES THAT ARE NECESSARY TO CONTINUE OUR PRODUCTION. The rate of production from crude oil and natural gas properties declines as reserves are depleted. Except to the extent we acquire additional properties containing proved reserves, or conduct successful exploration and development activities or, through engineering studies, identify additional formations with primary or secondary reserve opportunities on our own properties, our proved reserves will decline as reserves are produced. Future crude oil and natural gas production is therefore highly dependent on our level of success in finding and acquiring additional reserves. Our ability to continue acquiring producing properties or companies that own producing properties assumes that major integrated oil companies and independent oil companies will continue to divest many of their crude oil and natural gas properties. There can be no assurance that these divestitures will continue or that we will be able to acquire producing properties at acceptable prices. Our ability to develop additional reserves is limited by the terms of the new credit facility and the standby loan, each of which limits our ability to obtain additional financing in the future for acquisitions and capital expenditures. OUR PROFITABILITY IS HIGHLY DEPENDENT ON INDUSTRY CONDITIONS THAT HAVE, IN THE PAST, CAUSED US TO IMPLEMENT SIGNIFICANT WRITEDOWNS OF OUR ASSETS. Our revenue, profitability and future rate of growth substantially depend on prevailing prices for crude oil and natural gas. Crude oil and natural gas prices can be extremely volatile and in recent times have been depressed by excess total domestic and imported supplies. Prices are also affected by actions of state and local agencies, the United States and foreign governments and international cartels. Prices for crude oil and natural gas have recently rebounded from historic lows on an inflation-adjusted basis. There can be no assurance that commodity prices will rise or will not return to historic lows. These external factors and the volatile nature of the energy markets make it difficult to estimate future prices of crude oil and natural gas. The substantial and extended decline in the prices of crude oil and natural gas, until recently, adversely affected our financial condition and the results of our operations, including reduced cash flow and borrowing capacity, which has not been overcome by the most recent price rebound. All of these factors are beyond our control. We periodically review the carrying value of our crude oil and natural gas properties under the full cost accounting rules of the Securities and Exchange Commission. Under these rules, capitalized costs of proved oil and natural gas properties may not exceed a present value, based on flat prices at a single point in time, of estimated future net revenues from proved reserves, discounted at 10%. Application of the ceiling test generally requires pricing future revenue at the unescalated prices in effect as of the end of each fiscal quarter and requires a write-down for accounting purposes if the ceiling is exceeded. We were required to write down the carrying value of our crude oil and natural gas properties during 1998 by an aggregate of $188 million. We took a write-down of our Tunisian properties of $5.4 million during the third quarter of 1999 once it was determined that an exploratory well drilled in Tunisia, North Africa would not produce sufficient quantities of crude oil to justify further completion work on the well. When a write-down is required, it results in a charge to earnings, but does not affect cash flow from operating activities. Once incurred, a write-down of crude oil and natural gas properties is not reversible at a later date. WE RELY ON ESTIMATES OF PROVED RESERVES AND FUTURE NET REVENUE INFORMATION THAT ARE SUBJECT TO MANY FACTORS AND ANY NEGATIVE VARIANCE IN THESE ESTIMATES COULD AFFECT OUR REPORTED ASSETS AND OUR ABILITY TO BORROW FUNDS. There are numerous uncertainties inherent in estimating quantities of proved reserves and in projecting future rates of production and the timing of development expenditures, including many factors beyond our control. The reserve data included in this prospectus represent only estimates. In addition, the estimates of future net revenue from proved reserves and their present value are based on assumptions about future production levels, prices and costs that may not prove to be correct over time. In particular, estimates of crude oil and natural gas reserves, future net revenue from proved reserves and the present value of proved reserves for the crude oil and natural gas properties described in this prospectus are based on the assumption that future crude oil and natural gas prices remain the same as crude oil and natural gas prices at December 31, 1999. The NYMEX prices as of December 31, 1999, used for purposes of our estimates were $25.60 per Bbl of crude oil and $2.33 per Mcf of natural gas. Any significant variance in actual results from these assumptions could also materially affect the estimated quantity and value of our reserves. IF WE ARE UNABLE TO COMPETE EFFECTIVELY AGAINST MAJOR OIL COMPANIES AND OTHER INDEPENDENT OPERATORS, WE MAY BE UNABLE TO OBTAIN NECESSARY MATERIALS AND RESOURCES AND MAY EXPERIENCE A SIGNIFICANT DISRUPTION OF OUR OPERATIONS. We encounter strong competition from major oil companies and independent operators in acquiring properties and leases for the exploration for, and production of, crude oil and natural gas. Competition is particularly intense with respect to the acquisition of desirable undeveloped crude oil and natural gas properties. Many of our competitors have financial resources, staff and facilities substantially greater than ours. Although we believe our current operating and financial resources will be adequate to preclude any significant disruption of our operations in the immediate future, the continued availability of these materials and resources to us cannot be assured. WE ARE SUBJECT TO SIGNIFICANT GOVERNMENT REGULATION THAT MAY HINDER OUR ABILITY TO CONDUCT OUR BUSINESS. Our business is subject to federal, state, provincial and local laws and regulations relating to the exploration for and development, production and marketing of crude oil and natural gas, as well as environmental and safety matters. These laws and regulations have generally become more stringent in recent years, often imposing greater liability on a larger number of potentially responsible parties. Because the requirements imposed by these laws and regulations are frequently changed, we are unable to predict the ultimate cost of compliance with these requirements. There is no assurance that laws and regulations enacted in the future will not hinder our ability to conduct our business. For more information regarding regulations that affect us, see the sections of this prospectus called "Oil and Gas Operations -- Governmental Regulations" and "Oil and Gas Operations -- Environmental Regulations." WE HAVE A HIGH LEVEL OF DEPENDENCE ON TWO CUSTOMERS THAT CAN DIRECTLY AFFECT OUR INCOME STATEMENT. During 1999, two purchasers of our crude oil and natural gas, EOTT Energy Operating Limited Partnership and Amoco Production Company, accounted for 39% and 41%, respectively, of our revenues. While we believe that our relationships with EOTT and Amoco are good, any loss of revenue from these customers due to nonpayment by the customer would have an adverse effect on our net income and earnings per share on our income statement and, ultimately, may affect our share price. In addition, any significant late payment may adversely affect our short term liquidity position. OUR INDEPENDENT AUDITOR'S REPORT INDICATES THAT WE MAY NOT BE ABLE TO CONTINUE AS A GOING CONCERN. The independent auditor's report on our financial statements is qualified with respect to our ability to continue as a going concern. Specifically, the report notes that we had recurring losses, we defaulted on our old bank credit facility, and we had negative cash flow from operations in 1999. The financial statements included in this prospectus have been prepared assuming we will continue as a going concern, though that assumption may not necessarily be true. See the section of this prospectus called "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 2 to our consolidated financial statements included in this prospectus for more information regarding our ability to continue as a going concern. RISK FACTORS RELATING TO THE RIGHTS OFFERING AND OUR NEW COMMON STOCK SHAREHOLDERS WHO DO NOT EXERCISE THEIR RIGHTS WILL EXPERIENCE DILUTION. The rights offering, the issuance of additional shares to our standby lenders based on the success of the rights offering, and the issuance of additional shares to rights offering participants pursuant to the limited anti-dilution protection may result in our issuance of up to an additional 12,992,282 shares of our new common stock. These additional issuances assume full exercise of the rights, excluding the additional 10,000 shares of new common stock we are registering in this prospectus to account for the effects of rounding of rights being granted to shareholders. If you choose not to fully exercise your rights, your relative ownership interests will be diluted. If you do not exercise your rights, you will relinquish any value inherent in the rights. YOU MAY NOT REVOKE YOUR EXERCISE OF RIGHTS AND THE RIGHTS OFFERING MAY NOT BE COMPLETED. Once you exercise your rights, you may not revoke the exercise unless the conditions to our obligations to complete the rights offering are not satisfied or waived before the subscription period ends. In that case, we may extend the date the rights expire. If we extend the termination date of the rights, you will be able to change your decision. If we elect to withdraw or terminate the rights offering, neither we nor the subscription agent will have any obligation with respect to the rights except to return to you any subscription payments, without interest or deduction. THE SUBSCRIPTION PRICE MAY NOT REFLECT THE VALUE OF OUR SHARES. The subscription price does not necessarily bear any relationship to the book value of our assets, historic or future cash flows, financial condition, recent or historic prices for our old common stock or new common stock or other established criteria for valuation. You should not consider the subscription price as an indication of the value of our shares. See the section of this prospectus called "The Rights Offering and Plan of Distribution -- Determination of Subscription Price" for further detail regarding the way in which the subscription price was determined. THE ANTITAKEOVER EFFECTS OF SOME OF THE PROVISIONS OF OUR GOVERNING DOCUMENTS MAY PREVENT SOME TRANSACTIONS. Some of the provisions of our amended and restated articles of incorporation and amended and restated bylaws may tend to deter potential unsolicited offers or other efforts to obtain control that are not approved by our board of directors. These provisions include the right of our board of directors, without any action by our shareholders, to fix the rights and preferences of undesignated preferred stock, including dividend, liquidation and voting rights. All of these provisions apply to the new common stock, and may have the effect of delaying, deferring or preventing a change of control. IF OUR NEW COMMON STOCK IS NOT LISTED ON THE NASDAQ STOCK MARKET OR ANY OTHER STOCK EXCHANGE, THE PRICE OF THE NEW COMMON STOCK MAY BE DEPRESSED AND YOU MAY HAVE DIFFICULTIES RESELLING THE STOCK. We intend to explore the possibility of listing the new common stock on the Nasdaq Stock Market or on one or more other national securities exchanges. However, there can be no assurance that we will determine that it is feasible, practicable or advisable to list the new common stock or that, if an application is made, that the new common stock would be approved for listing. Our inability to secure the listing of the new common stock or the decision not to list the new common stock will affect the liquidity and marketability of the new common stock. Whether or not the new common stock is approved for listing on the Nasdaq Stock Market or any other national securities exchange, the new common stock may trade in the over-the-counter market. Even if the new common stock is approved for listing on the Nasdaq Stock Market or any other national securities exchange, there can be no assurance as to the price as to which any shares of the new common stock may be traded when issued or that an established market for those securities will develop.

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+RISK FACTORS In addition to the other information we provide in this prospectus, you should carefully consider the following risks before deciding whether to invest in our common stock. These are not the only risks we face. Some risks are not yet known to us and there are others we do not currently believe are material but could later turn out to be so. All of these could impair our business, operating results or financial condition. In evaluating the risks of investing in us, you should also evaluate the other information set forth in this prospectus, including our financial statements. THE ACQUISITION OF CAPITOL THRIFT IS NOT GUARANTEED AND THIS OFFERING IS NOT DEPENDENT ON SUCH ACQUISITION We have entered into a merger agreement to acquire Capitol Thrift which is subject to a number of conditions, including state and federal regulatory approval. While we intend to complete the acquisition of Capitol Thrift, no assurance can be given that it will be consummated and this offering is not conditioned upon the acquisition of Capitol Thrift. WE WILL NEED TO INTEGRATE AND OPERATE THE BUSINESS OF CAPITOL THRIFT & LOAN While we have experience in managing growth through branch acquisitions, Capitol Thrift represents our first major banking venture into areas of California other than Humboldt, Trinity, Mendocino and Placer Counties. Capitol Thrift also represents our first venture into acquiring a California industrial thrift and loan institution. Unlike Humboldt Bank and Capitol Valley Bank, Capitol Thrift almost exclusively relies on net income generated from loan interest income. We may experience: - problems integrating Capitol Thrift as our separate subsidiary; - unexpected employee departures; - computer hardware or software problems and coordination; or - the failure to maintain and improve customer service. CAPITOL THRIFT IS UNDER AN AGREEMENT WITH THE FDIC AND CALIFORNIA DEPARTMENT OF FINANCIAL INSTITUTIONS Capitol Thrift is subject to an agreement with the FDIC and California Department of Financial Institutions dated August 23, 1998. The agreement requires that Capitol Thrift: - develop a plan for the reduction of all classified assets; - develop specific strategies for the reduction of other real estate owned; - develop a plan to increase its Tier 1 capital. Although we believe that we have the business experience to address these issues, no assurance can be given that either the FDIC or California Department of Financial Institutions will not impose additional restrictions on Capitol Thrift's operations. ADVERSE PERFORMANCE OF CAPITOL THRIFT'S LOAN PORTFOLIO AND OUR FUTURE PERFORMANCE Making loans is the principal business of Capitol Thrift. Its operations and performance rely almost solely on generating loan interest income rather than other income and fees. Also, Capitol Thrift's existing loan portfolios differ to some extent in the types of borrowers, industries and credits represented by Humboldt Bank's and Capitol Valley Bank's loan portfolios. Our performance and prospects after the merger will be largely dependent on the performance of our combined loan portfolios with Capitol Thrift, and ultimately on the financial condition of their respective borrowers and other customers. Our failure to effectively manage the combined loan portfolio could have a material adverse effect on our business, financial condition and results of operations after the merger. Any decrease in loan customers could adversely effect our shareholders' return on equity and cause us to lose some of the anticipated benefit of the Capitol Thrift acquisition. For information about our loan portfolio, see "Humboldt Bancorp Management's Discussion and Analysis of Financial Condition and Results of Operation -- Loans." DEPENDENCE ON NON-TRADITIONAL BANKING INCOME FOR GROWTH Because of limited growth in the Humboldt-Eureka area, a substantial portion of our revenue is derived from non-traditional banking focused on fees on accounts, for services, leasing activity, and merchant bankcard processing. Although we intend to diversify our growth in other geographical areas through the acquisition of Capitol Thrift and operations of Capitol Valley Bank, increased competition within the banking industry could reduce fees on deposits and for services. With respect to merchant bankcard processing, we have focused our marketing to first-time merchants and small to medium-sized merchants in the retail, telephone, mail order and Internet commerce industries. Because these merchants are located outside our geographic location, they require more effort to monitor in the event the merchants experience a problem. See "Business of Humboldt Bancorp -- Merchant Bankcard." RECENT CHANGES MADE BY VISA WILL ADVERSELY AFFECT OUR MERCHANT BANKCARD OPERATIONS During November 1999, VISA adopted several rules in order to reduce risks in high risk merchant bankcard programs. Although Humboldt Bank does not believe that it operates a high risk merchant bankcard program, these new rules will adversely affect our operations. We are seeking a waiver from VISA. No assurance can be given that the waiver will be granted. See "Business of Humboldt Bancorp -- Merchant Bankcard." OUR STOCK OPTION PLAN CONTAINS AN ANTIDILUTION PROVISION Our stock option plan for directors, officers and employees contains a provision which grants additional options to the option holder in the event we issue additional shares, such as in this offering. The additional options that may be granted will have an exercise price equal to the fair market value at the time of grant. As a result of this provision, option holders will have the right to maintain their ownership interest in us. Further, because of these options, this may have the effect of impairing the price of our common stock or our ability to raise additional capital at a higher price due to the potential dilutive effect to new investors. OUR ACQUISITIONS AND GROWTH MAY STRAIN OUR PERSONNEL AND SYSTEMS We have grown substantially through branch acquisition activity, new bank and branch openings, the introduction of new product lines, and sustained increases in loans and deposits. Rapid growth has at times put high demands on our management and personnel, and has required increased expenditures for new employees, enhanced training, office space, and technology upgrades. WE FACE STRONG COMPETITION In recent years, competition for bank customers, the source of deposits and loans, has greatly intensified. This competition includes: - large national and super-regional banks which have well-established branches and significant market share in many of the communities we serve; - finance companies, investment banking and brokerage firms, and insurance companies that offer bank-like products; - credit unions, which can offer highly competitive rates on loans and deposits because they receive tax advantages not available to commercial banks; - government-assisted farm credit programs that offer competitive agricultural loans; - other community banks, including start-up banks, that can compete with us for customers who desire a high degree of personal service; - technology-based financial institutions including large national and super-regional banks offering on-line deposit, bill payment, and mortgage loan application services; and - other financial institutions offering merchant bankcard processing services. Other existing single or multi-branch community banks, or new community bank start-ups, have marketing strategies similar to ours. These other community banks can open new branches in the communities we serve and compete directly for customers who want the high level of service community banks offer. Other community banks also compete for the same management personnel and the same potential acquisition and merger candidates in Northern California. Historically, insurance companies, brokerage firms, credit unions, and other non-bank competitors have less regulation than banks and can be more flexible in the products and services they offer. Under the recently enacted Financial Services Act of 1999, most separations between banks, brokerage firms, and insurance companies are eliminated, which is likely to increase competition. See "Supervision and Regulation of Humboldt Bancorp, Humboldt Bank and Capitol Valley Bank -- Recent Legislation." DETERIORATION OF LOCAL ECONOMIC CONDITIONS COULD HURT OUR PROFITABILITY Our operations are primarily located in Northern California and are concentrated in Eureka and surrounding areas, and, to a lesser extent, Roseville, California. As a result of this geographic concentration, our financial results depend largely upon economic conditions in these areas. Adverse local economic conditions in Northern California, and in particular, Eureka, may have a material adverse effect on our financial condition and results of operations. GOVERNMENT REGULATION AND LEGISLATION COULD HURT OUR BUSINESS AND PROSPECTS We have extensive state and federal regulation, supervision and legislation which govern almost all aspects of our respective operations including: - the capital we must maintain; - the kinds of activities we can engage in; - the kinds and amounts of investments we can make; - the location of our offices. Bank regulation can hinder our ability to operate with financial services companies that are not regulated or are less regulated. This regulation is primarily intended for the protection of consumers, depositors, and deposit insurance funds and not for the protection of Humboldt Bancorp shareholders. See "Regulation of Humboldt Bancorp, Humboldt Bank, Capitol Valley Bank." LOSS OF KEY EMPLOYEES COULD HURT OUR PERFORMANCE The loss of the services of a key employee, or the failure to attract and retain other qualified persons, could have a material adverse effect on our business, financial condition and results of operations. We are heavily dependent on the services of Theodore S. Mason, our President and Chief Executive Officer, and on several other key executives, including Messrs. Ziegler, Dalby, and Musante, who have been instrumental in our growth. The operation and performance of Capitol Thrift is heavily dependent on the services of Mr. Robert F. Kelly, President and Chief Executive Officer, and Mr. Leighton Monroe, Jr., Chief Financial Officer, of Capitol Thrift. We intend to enter into employment arrangements with Mr. Robert F. Kelly and Mr. Leighton Monroe, Jr. for the continuation of their services for Capitol Thrift operations. Our rapid growth has placed significant demands on Mr. Mason's time, who until July 15, 1999, served as President and Chief Executive Officer of both Humboldt Bancorp and Humboldt Bank and Chairman of the Board of Capitol Valley Bank. As of December 31, 1999, Mr. Mason serves as President and Chief Executive Officer of Humboldt Bancorp, Mr. Paul Ziegler serves as Executive Vice President of Humboldt Bancorp, Mr. John Dalby serves as President and Chief Executive Officer of Humboldt Bank, and Mr. Musante serves as Vice President and Manager of the Merchant Bankcard Department of Humboldt Bank. We may need to recruit additional senior level executives as our growth continues. However, the market for qualified persons is competitive and they may be unwilling to relocate to Eureka, a non-metropolitan city. LIMITED TRADING MARKET FOR HUMBOLDT BANCORP COMMON STOCK AND PRICE VOLATILITY COULD MAKE IT DIFFICULT TO SELL SHARES AFTER THE OFFERING Subject to the close of this offering, our common stock has been approved for listing on the NASDAQ National Market. Our common stock is currently quoted on the OTC Bulletin Board. There is limited trading in our common stock. We do not know if an active trading market for our common stock will develop on the NASDAQ National Market. Given the limited trading history of our common stock on the OTC Bulletin Board and our inability to predict at what price level our common stock will trade in the future, the price of our common stock may fluctuate widely, depending on many factors that may have little to do with operating results or intrinsic worth, and you may encounter delay in selling your shares. For information about the trading history of Humboldt Bancorp's common stock, see "Market Prices."

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+RISK FACTORS An investment in our common stock involves a high degree of risk. You should consider carefully the following information about these risks, together with the other information contained in this prospectus, before you decide to buy our common stock. RISKS RELATED TO OUR BUSINESS BECAUSE WE HAVE A LIMITED OPERATING HISTORY, IT WILL BE DIFFICULT FOR YOU TO EVALUATE OUR BUSINESS AND PROSPECTS. Your evaluation of our business and its prospects will be more difficult because of our limited operating history. We began our operations in January 1996, so there is only a limited operating history upon which an evaluation of our business and its prospects can be based. When making your investment decision, you should consider the risks, expenses and difficulties that we may encounter or incur as a young company in a new and rapidly evolving market, and our need to manage expanding operations. Our business strategy may not be successful, and we may not successfully address these risks. WE HAVE HISTORICALLY INCURRED LOSSES, AND THESE LOSSES ARE LIKELY TO CONTINUE AND INCREASE IN THE FUTURE. We reported total net losses, including losses from discontinued operations of contract held for sale, of approximately $3.3 million, $4.9 million, $21.0 million and $22.4 million for the years ended December 31, 1996, 1997, 1998 and 1999, respectively. Because we expect to continue to incur significant sales and marketing, systems development, product development and administrative expenses, we will likely continue to incur losses and we will need to generate significant revenue to become profitable and sustain any profitability. We may not achieve or sustain our revenue or profit goals and our losses may continue or grow in the future. As a result, we may not be able to pursue our business strategy effectively. OUR BUSINESS WILL NOT GROW IF THE USE OF WIRELESS DATA SERVICES DOES NOT CONTINUE TO GROW. The markets for wireless data services and related products are still emerging, and growth in acceptance of these services remains uncertain. Current barriers to market acceptance of these services include carrier coverage, compatibility, interoperability, cost, speed, security and distribution channel constraints. We cannot be certain that these barriers will be overcome. Because the market for our wireless data services is new and evolving, it is difficult to predict the size of this market or its future growth rate, if any. Our future financial performance will depend in large part upon the increase in demand for data through wireless devices. We cannot assure you that a sufficient volume of subscribers will demand wireless data services. If the market for wireless data services grows more slowly than we currently anticipate, our revenue may not grow, which would adversely affect our results of operations and financial condition. WE WILL LIKELY NOT ACHIEVE PROFITABILITY IF THE WIRELESS DATA SERVICES WE OFFER FAIL TO ACHIEVE SIGNIFICANT MARKET ACCEPTANCE. Our services will have to achieve significant market acceptance for us to achieve profitability. Even if we do achieve significant market acceptance, we could lose that market acceptance if we fail to meet evolving customer technological or functional requirements on a timely basis. As a result of the complexities inherent in our service offerings, new wireless data services and service enhancements require significant development and testing periods. We may experience difficulties that could delay or prevent the successful development, introduction or marketing of new services or service enhancements. Additionally, any new services and service enhancements may not achieve market acceptance due to customer preferences for competing service offerings. If we cannot effectively maintain, improve and develop services to achieve and maintain significant market acceptance, we may not be able to recover our fixed costs or otherwise become profitable. MOST OF OUR REVENUE IS FROM NON-RECURRING PROJECTS, AND WE MAY NOT BE ABLE TO REPLACE THESE REVENUES WITH RECURRING REVENUES FROM SALES OF NEW PRODUCTS TO NEW MARKETS. Over 90% of our 1999 revenues was from non-recurring systems integration projects. We have limited experience providing wireless data services to customers, particularly to commercial customers. We intend over the next several quarters to significantly increase the percentage of our overall revenue that is derived from wireless data services. Providing wireless data services requires different skills on our part, including, but not limited to, marketing and sales. In addition, we intend, at the same time, to increase the percentage of revenue that is derived from commercial customers as opposed to public safety customers. It is not certain that we will be able to train our current employees to change successfully our operational focus, or be able to attract highly qualified employees for this business. The failure to attract recurring-revenue business will likely have an adverse effect on our business. WE DEPEND HEAVILY ON PUBLIC-SECTOR CONTRACT WORK, WHICH IS SUBJECT TO PUBLIC CONTRACTING UNCERTAINTIES. Approximately 90% of our 1999 revenues came from the public sector, particularly from law enforcement agencies. The capacity of public sector entities to pay for the services we offer hinges on the public sector budget, which to a large extent is determined by the political process. Pursuant to our contracts with public sector entities, the funding for such contracts may be reduced or eliminated and the applicable contract terminated. In addition, many of our agreements with public sector entities provide that the agreements may be terminated for the convenience of the public sector entity. Thus, there is an element of unpredictability in our most significant customer base. WE DEPEND ON A LIMITED NUMBER OF CUSTOMERS FOR A SIGNIFICANT MAJORITY OF OUR REVENUES. To date, a small number of customers have accounted for a significant majority of our revenues and will continue to do so for the foreseeable future. For the year ended December 31, 1999, we provided engineering services to the state of Delaware and the Florida Department of Law Enforcement, which accounted for approximately 16% and 15% of our revenues, respectively. Our five largest customers, in the aggregate, accounted for approximately 52% of our revenues during that period. For the year ended December 31, 1998, our four largest customers accounted for approximately 98% of our revenues. As of December 31, 1998, two customers accounted for 90% of accounts receivable and costs and estimated earnings in excess of billings under uncompleted contracts. If we lose one or more of our significant customers and do not attract additional customers, we may not generate sufficient revenues to offset this loss of revenues and our net loss will increase. In addition, if a significant customer fails to pay amounts it owes us, or does not pay those amounts on time, our revenues, operating results and financial position could suffer. WE OFFER FIXED-PRICE CONTRACTS; IF WE FAIL TO ESTIMATE ACCURATELY THE RESOURCES NECESSARY TO COMPLETE THESE CONTRACTS, WE MAY BE REQUIRED TO ABSORB COST OVERRUNS, WHICH WOULD ADVERSELY AFFECT OUR OPERATING RESULTS. Our engineering and implementation services contracts, which accounted for over 90% of our revenues in 1999, are fixed-price contracts, rather than time and materials contracts. These contracts involve risk because they require us to bear possible cost overruns, some of which may be beyond our control. Any such overruns would cause our net losses to increase. OUR REPORTED REVENUE NUMBERS MAY NOT PROVE TO BE COMPARABLE TO PRIOR OR FUTURE PERIODS BECAUSE ACCOUNTING FOR OUR REVENUES ON FIXED-COST CONTRACTS REQUIRES US TO ESTIMATE FUTURE COSTS, WHICH ARE UNCERTAIN. We account for our fixed-price contracts on a percentage-of-completion basis. This accounting method requires that, for each fixed-price contract in each period, we recognize expenses as incurred on the contract and recognize revenue based on a comparison of actual costs incurred for the project to our then-estimated total costs. Accordingly, the revenue we recognize in any given period depends to a significant extent on our estimate of the total remaining costs to complete individual projects. As with any estimates, our estimates of costs of completion are subject to numerous risks and uncertainties, including risks of increased costs for, or the unavailability of, personnel, communications hardware or wireless data airtime as well as technological risks in implementing our services on a timely basis. If in any period we significantly increase our estimate of the total cost to complete a project, we may recognize very little or no additional revenue with respect to that project. As a result, our gross margin in such period may not be directly comparable to prior or future periods and in such period and future periods may be significantly reduced. In some cases we may recognize a loss on individual projects prior to their completion. In 1998 and 1999, we increased our reserves for costs of completing existing contracts by approximately $2.6 million and $2.4 million, respectively. WE ARE NEGOTIATING THE ASSIGNMENT TO A THIRD PARTY OF A SIGNIFICANT SYSTEMS INTEGRATION CONTRACT THAT WE ACCOUNT FOR AS A DISCONTINUED OPERATION. Since 1996, we have been providing engineering and implementation services under a fixed-price contract with the City of New York to design and implement a payroll system. We recorded revenues of $440,000, $2.9 million and $5.7 million under this contract in 1997, 1998 and 1999, respectively. Total payments to us under the contract are scheduled to be $63.0 million from January 2000 to the expected completion of the project in 2003, assuming we meet specified performance milestones. In April 2000, we received a non-binding letter of intent relating to the assignment of our obligations under this contract. The letter of intent is subject to the assignee's due diligence and other conditions. Although we intend to assign this contract, we may experience difficulties that could delay or prevent the successful assignment of the contract. Some of these possible difficulties are beyond our control. For example, the City of New York must consent to any assignment of our obligations under the contract to a third party. Any delay in, or failure to complete, the assignment of this contract could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect our results of operations. HIGHLY-SKILLED EMPLOYEES, PARTICULARLY PROJECT MANAGERS AND OTHER SENIOR TECHNICAL PERSONNEL, ARE DIFFICULT TO ATTRACT AND RETAIN AND OUR FAILURE TO ATTRACT AND RETAIN THESE PERSONNEL WOULD IMPAIR OUR ABILITY TO COMPLETE PROJECTS AND EXPAND OUR BUSINESS. Our business is labor-intensive. Our success will depend significantly upon our ability to attract, retain, train, and motivate highly-skilled employees, particularly project managers and other senior technical personnel. Any failure on our part to do so would impair our ability to adequately manage and complete our existing projects, bid for and obtain new projects, and expand our business into wireless data applications and related services. If our employees are unable to achieve expected performance levels, our business and strategies will suffer. There exists significant competition for employees with the skills required to perform the services we offer. Qualified project managers and senior technical staff are in great demand and are likely to remain a limited resource for the foreseeable future. There can be no assurance that we will be successful in attracting a sufficient number of highly-skilled employees in the future, or that we will be successful in retaining, training, and motivating the employees we are able to attract. ANY RAPID GROWTH MAY STRAIN OUR RESOURCES AND HINDER OUR ABILITY TO IMPLEMENT OUR BUSINESS STRATEGY. Our historical growth has been limited. Significant future growth would place a significant strain on our resources. Our ability to achieve and maintain profitability will depend on our ability to manage our growth effectively, to implement and expand operational and customer support systems and to hire personnel. We may not be able to augment or improve existing systems and controls or implement new systems and controls to respond to any future growth. In addition, future growth may result in increased responsibilities for our management personnel, which may limit their ability to manage our business effectively. BECAUSE WE HAVE ONLY RECENTLY ASSEMBLED OUR MANAGEMENT TEAM, WE CANNOT ASSURE YOU THAT THEY CAN EFFECTIVELY WORK TOGETHER TO OPERATE OUR BUSINESS. We have recently expanded our management team significantly, adding new executive officers in numerous functions. These individuals have generally not worked with one another before, and we may not be able to forge an effective working relationship among them. Moreover, all of our new managers are still learning about our company and our industry. If our senior management cannot work together effectively, then our business and strategies will be harmed and we will incur additional costs in seeking and retaining new management personnel. THE LOSS OF OUR KEY EXECUTIVES WOULD DISRUPT OUR BUSINESS. We rely on the leadership and vision of key members of our senior management team, particularly Bruce Boisture, our Chairman, Chief Executive Officer and President. The members of our senior management team are instrumental to the management and growth of our business. The loss of any of these executives would disrupt our growth or result in lost revenues or an increase in net losses. We do not currently maintain key-man life insurance policies covering any of our senior executives. IF WE DO NOT RESPOND EFFECTIVELY AND ON A TIMELY BASIS TO RAPID TECHNOLOGICAL CHANGE AFFECTING OUR MARKETS, OUR SERVICES MAY BECOME OBSOLETE AND WE MAY LOSE SALES. The wireless and data communications industries are characterized by rapidly changing technologies, industry standards, customer needs and competition, as well as by frequent, new, and often increasingly sophisticated, product and service introductions. Our services are integrated with wireless devices and the computer systems of our customers. Our services must also be compatible with the data networks of wireless carriers. We must respond to technological changes affecting both our customers and suppliers to ensure that our services are and remain compatible with the technologies they use. We may not be successful in developing and marketing, on a timely and cost-effective basis, new services that respond to these technological changes, evolving industry standards or changing customer requirements and as a result, we would lose sales and our results of operations and financial condition would suffer. BECAUSE WE RELY HEAVILY ON THE SUCCESSFUL OPERATION OF OUR NETWORK OPERATIONS CENTER, DISRUPTIONS IN ITS OPERATIONS WOULD ADVERSELY AFFECT OUR ABILITY TO PROVIDE SERVICES TO OUR CUSTOMERS. Our network operations center is a central aspect of our provision of services to our customers, particularly our hosting services. Any disruption in the operation of our network operations center as a result of accidental or intentional security breaches, improper access to or transmission of customer data, any systems failure or for any other reason would negatively impact our operations. We may not be able to avoid any such disruption. Maintaining and upgrading our network operations center to ensure adequate reliability and functionality, particularly in light of the rapidly changing technologies in the wireless data services market, will require significant future capital expenditures and other resources. WE DEPEND UPON WIRELESS NETWORKS OWNED AND CONTROLLED BY OTHERS. IF WE DO NOT HAVE CONTINUED ACCESS TO SUFFICIENT CAPACITY ON RELIABLE NETWORKS AT PRICES ATTRACTIVE TO OUR CUSTOMERS, WE MAY BE UNABLE TO DELIVER OUR SERVICES. Our ability to grow and achieve profitability partly depends on our ability to buy sufficient capacity on the networks of wireless carriers such as AT&T Wireless Services or Bell Atlantic Mobile and on the reliability and security of their systems. All of our services are delivered using airtime purchased from third parties. We depend on these companies to provide uninterrupted and "bug free" service and would not be able to satisfy our customers' needs if they failed to provide the required capacity or needed level of service. In addition, our expenses and our net loss would increase materially if wireless carriers were to increase the prices of their services, because some of our customer contracts would not permit us to charge these increased costs to the customer. Also, some of these wireless carriers are, or could become, our competitors, and if they compete with us they may choose not to provide us with their services or raise their prices. OUR NETWORK SOFTWARE MAY CONTAIN DEFECTS OR ERRORS, AND OUR SALES WOULD DECREASE IF THIS INJURES OUR REPUTATION. The Paradigm4 Wireless DataNet network is complex and must meet the stringent technical requirements of our customers. We must develop our services quickly to keep pace with the rapidly changing software and telecommunications markets. Software as complex as ours is likely to contain undetected errors or defects, especially when first introduced or when new versions are released. Our software may not be free from errors or defects after delivery to customers has begun, which could result in the rejection of our software or services, damage to our reputation, deferred or lost revenue, diverted development resources and increased development, service and warranty costs. WE MAY ACQUIRE TECHNOLOGIES OR COMPANIES IN THE FUTURE, AND THESE ACQUISITIONS COULD DISRUPT OUR BUSINESS AND DILUTE YOUR HOLDINGS IN OUR COMPANY. We may acquire technologies or companies in the future, especially to establish our wireless data services. Entering into an acquisition entails many risks, any of which could materially harm our business, including: - diversion of management's attention from other business concerns; - failure to assimilate effectively the acquired technology or company into our business; - the loss of key employees from either our current business or the acquired business; and - assumption of significant liabilities of the acquired company. To date, we have not completed any material acquisitions, and we may not be able to do so in an effective manner. In addition, it is likely that we will issue equity securities to pay the costs of certain acquisitions, and your holdings in our company will be diluted if we do so. WE EXPECT TO RELY ON STRATEGIC PARTNERSHIPS TO ATTRACT AND RETAIN CUSTOMERS. Our business strategy requires us to establish strategic relationships with application developers such as Wireless Knowledge Inc., a joint venture of Microsoft Corporation and Qualcomm, Inc., and others. Such relationships are expected to allow us to offer our customers a broad product selection and products that have already gained wide market acceptance. There can be no assurance that we will be able to establish and maintain necessary strategic relationships. If we fail to establish or maintain necessary strategic relationships in the future, we may be unable to attract additional customers or retain our current customers, and our revenue and results of operations could be adversely affected. Under certain circumstances, others may have the ability to resell Wireless Knowledge's Workstyle Server product to the government sector in North America and to provide a similar, or the same, managed service to all North American sectors. In addition, Microsoft Corporation and Qualcomm, Inc., as part of the joint venture that formed Wireless Knowledge, retain rights to Wireless Knowledge technology and could offer competing products or services themselves. If Microsoft, Qualcomm or others devoted substantial resources to marketing Workstyle Server, the value of our strategic relationship with Wireless Knowledge would be diminished and our business would suffer. As part of the agreement, we have committed to purchase for resale 150,000 Workstyle Server licenses over a 42-month period. OUR FAILURE TO DEVELOP RECOGNITION FOR THE PARADIGM4 BRAND COULD PREVENT US FROM ACHIEVING A PROFITABLE LEVEL OF SALES. Our selling and marketing activities to date have been limited and, as a result, there is very limited customer awareness of our service offerings, particularly in the commercial market for wireless data services. Our selling and marketing expenses were $3.7 million for the year ended December 31, 1998 and $3.6 million for the year ended December 31, 1999. We will seek to increase the market presence of our brand over time, which will require us to increase the amount we spend on selling and marketing significantly. We may lose existing customers or fail to attract new customers if the Paradigm4 brand is not well received by our customers, if our marketing efforts are not productive, if we are otherwise unsuccessful in increasing our brand awareness or if our competition has greater brand recognition. WE INTEND TO SUPPLEMENT OUR INTERNAL MARKETING AND SALES EFFORTS THROUGH ARRANGEMENTS WITH THIRD PARTIES. IF THE MARKETING EFFORTS OF THESE THIRD PARTIES ARE NOT EFFECTIVE, WE WILL BE UNLIKELY TO ACHIEVE A PROFITABLE LEVEL OF SALES. We intend to rely significantly on the efforts of others, such as wireless service providers, systems integrators, hardware manufacturers, resellers and software developers, to supplement our internal sales and marketing efforts. We are in the early stage of developing our relationships with many of these developers, and we cannot control how they perform or whether their performance will be satisfactory. If these third parties fail to market our services or their efforts fail to result in new customers, we may be unable to attract new customers and our revenue would be adversely affected. If these third parties fail to market our services adequately, we would be forced to increase our sales and marketing staff, which would materially increase our fixed costs. WE MAY FAIL TO SUPPORT GROWTH IN OPERATIONS, WHICH COULD REDUCE DEMAND FOR OUR SERVICES AND MATERIALLY ADVERSELY AFFECT OUR REVENUE. Our business strategy assumes that our number of customers, the amount of information they want to receive and the number of services we offer will all increase. We must continue to develop and expand our systems and operations to accommodate this assumed growth. The expansion and adaptation of our wireless data services requires substantial financial, operational and management resources. We may be unable to expand our operations for one or more of the following reasons: - we may not be able to locate or hire at reasonable compensation rates qualified engineers and other employees necessary to expand our capacity; - we may not be able to obtain the hardware necessary to expand our capacity; - we may not be able to expand our customer service, billing and other related support systems; and - we may not be able to obtain sufficient additional capacity from wireless carriers. The expansion of our systems and operations could also be affected by a lack of available funding either through cash from operations or through financings. Due to the limited deployment of our services to date, we cannot be sure that our systems and operations will maintain an acceptable level of performance if we are required to connect and manage a substantially larger number of customers. Any failure on our part to develop and maintain our wireless data services as we experience rapid growth could significantly reduce demand for our services. WE MAY NOT HAVE ADEQUATELY PROTECTED OUR INTELLECTUAL PROPERTY RIGHTS, WHICH COULD ALLOW COMPETITORS TO DEVELOP SIMILAR PRODUCTS USING SIMILAR TECHNOLOGY. Our success depends significantly on our technology and other proprietary rights relating to our services. We will be relying on a combination of patent, copyright, trademark, service mark and trade secret laws, confidentiality procedures and contractual provisions to establish and protect such proprietary rights. We have received a patent for our enterprise messaging system software and are pursuing registration of our trademarks and/or service marks. Despite the measures we have taken and expect to take to protect our intellectual property, these steps may prove to be inadequate. For example, patents may be allowed or issued to others based on our pending or future patent applications, patents may be successfully challenged or circumvented, or rights granted under any patent that may be issued or licensed to us may not provide us with a competitive advantage. Our trademarks and service marks may not have the distinctiveness necessary to offer our business competitive advantages, and our registrations may not be enforceable. We may not be able to obtain future registrations. We are pursuing federal registrations for various trademarks and/or service marks for which we already have common-law trademark rights based on our use of such marks in interstate commerce. We may not be able to use these names effectively or at all if we fail to obtain such registrations due to conflicting marks or otherwise. In addition, third parties may breach the confidentiality obligations that they have to us under our contracts with them, or misappropriate or infringe our intellectual property rights, or that adequate remedies will be available to us if a breach, misappropriation or infringement occurs. In addition, our competitors or other third parties may independently develop competing technologies, reverse-engineer our software or other technologies or even design around our intellectual property rights. If our competitors are able to develop similar products or services using similar technology, any competitive advantage we have will be compromised and our revenues could decrease. OUR CONTRACTUAL RIGHTS TO THIRD PARTY INTELLECTUAL PROPERTY MAY BE INSUFFICIENT TO SECURE RIGHTS NECESSARY FOR THE USE OF OUR TECHNOLOGIES OR MAY BE SUCCESSFULLY CHALLENGED. A significant element of our business strategy is to develop wireless data applications for specific markets that have wider applicability, either to additional participants in those markets or, with modification, to other, broader, markets. Because some aspects of our technologies are developed with the assistance of third party consultants or in connection with customized development for our customers, we depend on contractual provisions to ensure that we obtain the intellectual property rights necessary for the use of the developed technologies. We cannot assure you that such provisions will be sufficient to secure the necessary rights to the developed technologies, or that we will not be subject to claims by our consultants or customers that they have rights to part or all of the developed technology. In the past, we have developed applications for third parties without retaining the right to use all associated intellectual property. We are currently working to obtain exclusive license rights to certain technology that we use in key aspects of our business. If we fail to obtain this license or are unable to do so on commercially reasonable terms, we will experience significant delays and incur significant additional expenses to pursue and implement our business strategy. OUR LOSS OF OR INABILITY TO MAINTAIN OR OBTAIN ANY REQUIRED INTELLECTUAL PROPERTY COULD LEAD TO A RELIANCE ON MORE EXPENSIVE OR LOWER QUALITY OR PERFORMANCE TECHNOLOGY, OR FORCE US TO CEASE OFFERING OUR PRODUCT OR SERVICE. We also rely on certain technologies that we license from third parties including certain third-party software that may not be available to us in the future on commercially reasonable terms or at all. Our loss of or inability to maintain or obtain, any required intellectual property could require us to use substitute technology, which could be more expensive or of lower quality or performance, or force us to cease offering our product or service. Either of these results would have a material adverse effect on our business, financial condition or results of operations. Moreover, some of our license agreements are non-exclusive, and our competitors, therefore, may have access to the same technology that we license. WE MAY BE SUED BY THIRD PARTIES FOR INFRINGEMENT OF THEIR INTELLECTUAL PROPERTY RIGHTS AND INCUR COSTS OF DEFENSE AND POSSIBLY ROYALTIES OR LOSE THE RIGHT TO USE TECHNOLOGY IMPORTANT TO PROVIDING OUR PRODUCTS OR SERVICES. Third parties could claim infringement by us with respect to current or future products or services. As the number of entrants into our market increases, the possibility of an infringement claim against us grows. We may be inadvertently infringing a patent of which we are unaware. In addition, because patent applications can take many years to issue, there may be a patent application now pending of which we are unaware, which will cause us to be infringing when it issues in the future. Any infringement claim, whether meritorious or not, could be time-consuming, result in costly litigation, cause service installation delays or require us to enter into royalty or licensing agreements. Royalty or licensing agreements might not be available on terms acceptable to us or at all. As a result, any claim could have a material adverse effect upon our business, financial condition or results of operations. DISRUPTION OF OUR SERVICES DUE TO ACCIDENTAL OR INTENTIONAL SECURITY BREACHES MAY HARM OUR REPUTATION, CAUSING A LOSS OF SALES AND WOULD INCREASE OUR EXPENSES. A significant barrier to the growth of wireless data services has been the need for secure transmission of confidential information. Our systems could be disrupted by unauthorized access, computer viruses and other accidental or intentional actions. In addition, many of our customers are law enforcement agencies and, as such, are especially sensitive to breaches of security. We may incur significant costs to protect against the threat of security breaches or to alleviate problems caused by such breaches. If a third-party were able to misappropriate our users' personal or proprietary information or credit card information, we could be subject to claims, litigation or other potential liabilities that could materially adversely impact our revenue and may result in the loss of customers. ANY TYPE OF SYSTEMS FAILURE COULD REDUCE SALES, OR INCREASE COSTS, OR RESULT IN CLAIMS OF LIABILITY. Any disruption from landline connections could result in delays in our customers' abilities to exchange information. There can be no assurance that our systems will operate appropriately if we experience a hardware or software failure or if there is an earthquake, fire or other natural disaster, a power or telecommunications failure, an act of God or an act of war. A failure in our own or our carriers' systems could cause delays in transmitting data, and as a result we may lose customers or face litigation that could involve material costs and distract management from operating our business. COMPETITORS COULD IMPAIR OUR ABILITY TO SELL NEW AND EXISTING SERVICES AT A PROFIT. Intense competition is developing in the market for services we offer. We developed our software using standard industry development tools. Our agreements with wireless carriers, equipment suppliers, and other vendors and partners are often non-exclusive. Our competitors may use the same products and services in competition with us. With time and capital, it would be possible for competitors to replicate our services. Many of our competitors have significantly greater resources than we do. In particular, wireless network carriers have a built-in cost advantage due to their ownership of wireless networks and have significant application engineering expertise and personnel. Competition could reduce our market share or force us to lower prices to unprofitable levels. See "Business -- Competition."

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+RISK FACTORS YOU SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW BEFORE MAKING AN INVESTMENT DECISION. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCUR, OUR BUSINESS AND FINANCIAL RESULTS MAY SUFFER. IN THAT CASE, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE AND YOU COULD LOSE ALL OR PART OF YOUR INVESTMENT. BECAUSE WE HAVE OFFERED OUR BILLABLE PREMIUM SERVICES FOR ONLY SIX QUARTERS AND OUR FREE BASIC SERVICE IN ITS CURRENT FORM FOR LESS THAN ONE QUARTER, THERE IS LIMITED INFORMATION UPON WHICH YOU CAN EVALUATE OUR BUSINESS We have a limited operating history upon which you can evaluate our business and our services. We began offering our free basic service to the public in its original form in April 1996, first offered billable premium services to the public in July 1998 and expanded our basic service to include free Internet access in addition to e-mail in December 1999. As a company in the new and rapidly evolving market for Internet services, we face numerous risks and uncertainties. Some of these risks relate to our ability to: - attract and retain subscribers to our free basic service and our billable premium services; - anticipate and adapt to the changing Internet market; - generate advertising and electronic commerce revenues; - maintain and develop strategic relationships with business partners to market their products over our services; - implement an effective marketing strategy to promote awareness of the Juno services; - respond to actions taken by our competitors and the entry of new competitors into our markets; - develop and deploy successive versions of the Juno software; - operate computer systems and related infrastructure adequate to effectively manage our growth and provide our basic service and our billable premium services; - develop, deploy and operate broadband Internet access services, whether independently or in collaboration with one or more third parties; - manage the billing systems used to invoice subscribers to our billable premium services; and - attract, retain and motivate qualified personnel. Our business and financial results will depend heavily on the commercial acceptance and profitability of both our free basic and our billable premium services. If we are unsuccessful in addressing these risks or in executing our business strategy, our business and financial results may suffer. Please see "Management's Discussion and Analysis of Financial Condition and Results of Operations" for detailed information on our limited operating history. WE HAVE A HISTORY OF LOSSES SINCE OUR INCEPTION IN 1995 AND EXPECT CONTINUED LOSSES FOR THE FORESEEABLE FUTURE Since our inception in 1995, we have not been profitable. We have incurred substantial costs to create and introduce our various services, to operate these services, to promote awareness of these services and to grow our business. We incurred net losses of approximately $3.8 million from inception through December 31, 1995, $23.0 million for the year ended December 31, 1996, $33.7 million for the year ended December 31, 1997, $31.6 million for the year ended December 31, 1998 and $55.8 million for the year ended December 31, 1999. As of December 31, 1999, our accumulated net losses totaled $148.0 million. We incurred negative cash flows from operations of approximately $16.4 million for the year ended December 31, 1996, $33.6 million for the year ended December 31, 1997 and $20.9 million for the year ended December 31, 1998. For the year ended December 31, 1999, we used $36.4 million in cash for working capital purposes and to fund losses from operations. Additionally, at December 31, 1999, $8.7 million remained prepaid for advertising that may be used at any time prior to March 2001, bringing total net cash used in operating activities to $45.1 million. Since we operated as a limited partnership prior to the merger of Juno Online Services, L.P. into Juno Online Services, Inc. in March 1999, taxable losses incurred prior to the merger were allocated to the partners of Juno Online Services, L.P. for reporting on their income tax returns. As a result, we will not be able to offset future taxable income, if any, against losses incurred prior to the merger. We expect operating losses and negative cash flows to continue for the foreseeable future as we continue to incur significant expenses. We cannot assure you that we will ever be successful in implementing our business strategies or in addressing the risks and uncertainties facing our company. Even if we do address these risks successfully, we may not be profitable in the future. Were we to achieve profitability, we cannot assure you that we would be able to sustain or increase profitability on a quarterly or annual basis in the future. Please see "Selected Consolidated Financial Data" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" for more detailed information. JUNO'S BUSINESS IS SUBJECT TO FLUCTUATIONS IN OPERATING RESULTS WHICH MAY NEGATIVELY IMPACT THE PRICE OF OUR STOCK Our revenues, expenses and operating results have varied in the past and may fluctuate significantly in the future due to a variety of factors, many of which are outside of our control. These factors include, among others: - the rate of new subscriber acquisitions and seasonal trends relating to subscriber usage of our services; - the timing and effectiveness of our marketing efforts to acquire subscribers and promote the Juno brand; - the timing and effectiveness of any revenue sharing arrangements or other strategic alliances into which we enter; - the demand for Internet advertising and seasonal trends relating to Internet advertising spending; - seasonal trends relating to the demand for products sold over the Internet; - capital expenses related to upgrading our computer systems and related infrastructure; - our ability to protect our systems from any telecommunications failures, power loss, or software-related system failures; - our ability to integrate operations and technologies from any acquisitions or other business combinations or relationships into which we enter; - the extent to which we experience increased competition in the markets for Internet services, Internet advertising and electronic commerce; - changes in operating expenses including, in particular, telecommunications expenses and the cost of providing various types of technical and non-technical customer support to our subscribers; and - economic conditions specific to the Internet as well as general economic and market conditions. Since we expect to be heavily dependent on revenues from our billable premium services in the foreseeable future, our revenues are likely to be particularly affected by our ability to recruit new subscribers directly to our billable premium services, upgrade users of our free basic service to our billable premium services, and retain subscribers to our billable premium services. In addition, our operating expenses are based on our expectations of our future revenues and are relatively fixed in the short term. We may be unable to adjust spending quickly enough to offset any unexpected revenue shortfall, which may cause our business and financial results to suffer. Due to all of the above factors and the other risks discussed in this section, you should not rely on quarter-to-quarter comparisons of our results of operations as an indication of future performance. It is possible that in some future periods our results of operations may be below the expectations of public market analysts and investors. In this event, the price of our common stock is likely to fall. Please see "Management's Discussion and Analysis of Financial Condition and Results of Operations" for detailed information on our operating results. THE EXPANSION OF OUR FREE BASIC SERVICE TO INCLUDE FULL WEB ACCESS INCREASES OUR TELECOMMUNICATIONS COSTS AND EXPOSES US TO ADDITIONAL BUSINESS RISKS In December 1999, we announced the expansion of our free basic service to include full Internet access, including access to the World Wide Web. We face numerous costs, risks, and uncertainties associated with this expansion, including the following: - OUR TELECOMMUNICATIONS COSTS WILL INCREASE SIGNIFICANTLY. When using e-mail, subscribers need to be connected to our central computers for the relatively short period of time required to send e-mail they have written or download e-mail that has been sent to them. When using the Web, a subscriber must remain continuously connected to the Internet for the entire duration of a Web session. The expansion of our free basic service to include Web access is therefore expected to increase the amount of time that users spend connected, and correspondingly to increase our telecommunications costs both on an absolute and a per-subscriber basis. The expansion of the service may also attract a large number of new subscribers to our free basic service, further increasing our telecommunications costs on an absolute basis. Our telecommunications costs represent one of the most significant expenses of providing our free basic service. We cannot assure you that we will be able to achieve reductions in our per-subscriber telecommunications costs, and if we are unable to achieve such reductions, our business and financial results will suffer. Please see "--The economic viability of our expanded free basic service may depend on our ability to obtain telecommunications capacity on a fixed-price basis." - OUR PAYING SUBSCRIBERS MAY CANCEL THEIR BILLABLE SERVICE SUBSCRIPTIONS AND SWITCH TO THE EXPANDED FREE SERVICE. Now that users of our basic service can access the Web for free, it is likely that some, and possibly many, Juno Web subscribers will cancel their billable service subscriptions and switch to the free basic service. If the number of Juno Web subscribers who switch to the free basic service is significant, our business and financial results may suffer. - USERS OF OUR EXPANDED FREE BASIC SERVICE MAY REACT NEGATIVELY TO THE PERSISTENT ADVERTISING BANNER DISPLAYED WHILE THEY USE THE WEB. Users of our expanded free basic service are required to view a prominent advertising and navigation banner at all times while they are connected to the Web. Some users, particularly those using low-resolution computer monitors to view the Web, may consider this banner to be intrusive to an extent that interferes with their use of the service. Some competitors have introduced free Internet access services that do not require the user to view an additional advertising banner. If these competitive services become popular, or if additional competitors introduce free Internet access services that do not require the user to view a persistent advertising banner, then our ability to retain users of our free basic service or our ability to derive revenue by displaying advertisements to such users may be harmed. - REVENUES GENERATED FROM THE SALE OF ADDITIONAL ADVERTISING INVENTORY CREATED BY THE EXPANSION OF OUR FREE BASIC SERVICE MAY BE INSUFFICIENT TO COVER OUR INCREASED COSTS. The expansion of our free basic service may make us more dependent on advertising as a source of revenue in the future. The addition of a persistent advertising banner displayed to users of our expanded basic service when they use the Web is expected to create a significant amount of advertising inventory. However, there can be no assurance that we will be able to generate revenues from the sale of this new advertising inventory, or that any portion of it that we are able to sell will be sold at favorable rates. If we are unable to sell this inventory or to do so at favorable rates, our business and financial results may suffer. OUR BUSINESS MAY SUFFER IF WE HAVE DIFFICULTY ACQUIRING SUBSCRIBERS TO OUR SERVICES We may not succeed in acquiring a sufficiently large subscriber base for our free basic service and our billable premium services, or in persuading a significant number of our free basic subscribers to upgrade to our premium services. To acquire new members, we currently rely on multiple distribution channels for our free proprietary software that enables subscribers to use our services. Our ability to recruit new subscribers may depend on our ability to enter into additional distribution agreements and to retain our current distribution partners. We cannot be sure that we will be able to enter into additional, or maintain or replace our current, distribution agreements on favorable terms, or that any of our distribution partners will be able to market our services effectively. Many of our distribution partners also distribute competing products, and are free to terminate our distribution arrangements at their convenience. Our inability to recruit, manage or retain distribution partners, or the inability of these distribution partners to effectively promote and distribute our software, may cause our business and financial results to suffer. Our business strategy contemplates that a significant percentage of the subscribers to our free basic service will decide over time to upgrade to our premium services. We are relying on this migration as a major source of subscribers to our billable premium services and, since July 1998, we have conducted advertising to our free basic service subscribers to encourage them to upgrade. Over time, repeated exposure to these advertisements may cause their effectiveness to decline. As a result, we expect that we will need to rely on more expensive forms of external marketing and promotion to attract additional users directly to our billable premium services, as well as to attract new users to our free basic service. If our marketing techniques fail to generate the anticipated conversion rate from free to billable premium services, if the acquisition cost for subscribers acquired directly into our billable premium services is greater than expected, or if technical limitations make the conversion process more difficult or time-consuming than anticipated, our business and financial results may suffer. Please see "--Our marketing program may not succeed in generating new subscribers or in persuading subscribers to upgrade to our premium services" for more information on our marketing activities. DIFFICULTY RETAINING SUBSCRIBERS TO OUR SERVICES MAY CAUSE OUR BUSINESS TO SUFFER Our business and financial results are also dependent on our ability to retain subscribers to our services. Each month, a significant number of subscribers to our billable premium services choose to cancel the service. In addition, each month a significant number of subscribers to our free basic service become inactive. As a result, the total number of subscribers using our services in a given month has remained at between 2.2 million and 2.4 million since March 1998, even though we have added new subscribers during that period. We believe that intense competition has caused, and may continue to cause, some of our subscribers to switch to other services. It is easy for Internet users to switch to competing providers and we cannot be certain that any steps we take will maintain or improve subscriber retention. In addition, new subscribers may decide to use our services out of curiosity regarding the Internet, or to take advantage of free or low-cost introductory offers for our billable premium services, and may later discontinue using our services. Furthermore, we may in the future charge a fee for our basic service or limit the amount a subscriber may use this service in a given period. In the event we were to implement these kinds of charges or restrictions, we may lose a significant number of our basic service subscribers. If we are unable to retain subscribers to both our basic service and our billable premium services, or if we experience an increase in the rate of cancellations by subscribers to our billable premium services, our business and financial results may suffer. Please see "--Competition in the markets for Internet services, Internet advertising and electronic commerce is likely to increase in the future and may harm our business" for more information concerning the competition facing our business. SOME USERS OF OUR FREE BASIC SERVICE MAY BE UNABLE TO ACCESS THE WEB In order to obtain access to the Web, users of our free basic service must be equipped with the latest version of our software, version 4.0, as well as a recent version of Microsoft Internet Explorer, the Web browsing software that our free basic service requires. Approximately 45% of our free basic service users currently use versions of our software older than version 4.0. Although we plan to upgrade such users' software to version 4.0 automatically by downloading the newer version to their computer during one of their connections, technical constraints prevent us from completing automatic upgrades for users of the oldest versions of our software. Instead, these users must choose to install the current version of our software and, in some cases, need to be sent a copy of the software by mail before they can complete this process. Approximately 6% of our free basic service users currently use a version of the Microsoft Windows operating system older than Windows 95, and cannot upgrade to version 4.0 of the Juno software unless they upgrade to a more current version of Windows. There is a risk that some portion of our basic service user base will never upgrade to version 4.0 of the Juno software and will be unable to access the Web through our free basic service. In addition, to avoid straining our telecommunications resources, we are employing a staggered roll-out strategy in upgrading basic service users' software to version 4.0 and in notifying such users about the expansion of the service to include Web access. Since we do not expect to complete this upgrade process before the second quarter of 2000 at the earliest, a significant portion of those basic service users who can be upgraded to version 4.0 may not be upgraded for at least several months. If a significant percentage of our basic service users do not begin using the Web, our ability to display Web-related advertisements and generate associated revenues may be harmed. OUR MARKETING PROGRAM MAY NOT SUCCEED IN GENERATING NEW SUBSCRIBERS OR IN PERSUADING SUBSCRIBERS TO UPGRADE TO OUR PREMIUM SERVICES We expect to use a significant portion of the proceeds from this offering for an extensive marketing campaign. This campaign will be directed at encouraging users to sign up directly for either our free basic service or our billable premium services and persuading users of our free basic service to upgrade to our billable premium services. This marketing program may include forms of advertising, such as television and radio advertising, with which we have limited experience. There are risks that this campaign may not be effective in accomplishing one or both of these goals. In addition, it is possible that, over time, it will become more difficult and expensive to effectively market our premium services to users of our free basic service and that the rate at which users of the free basic service upgrade to our billable premium services will decline. We also do not know what kind of advertising our competitors will undertake or the timing and extent of advertising by our competitors. Many of our competitors have greater financial resources than we do and have undertaken significant advertising campaigns utilizing the same advertising media that we use. It is possible that these campaigns will have an adverse effect on our own marketing plans or expenses. If we incur significant costs in implementing our marketing program without generating sufficient new subscribers to our services, our business and financial results will suffer. COMPETITION IN THE MARKETS FOR INTERNET SERVICES, INTERNET ADVERTISING AND ELECTRONIC COMMERCE IS LIKELY TO INCREASE IN THE FUTURE AND MAY HARM OUR BUSINESS The market for Internet services is extremely competitive and includes a number of substantial participants, including America Online, Microsoft and AT&T. The markets for Internet-based advertising and electronic commerce are also very competitive. Our ability to compete depends upon many factors, many of which are outside of our control. INTENSE COMPETITION EXISTS IN THE MARKET FOR INTERNET SERVICES We may not be able to compete successfully against current or future competitors, and the competitive pressures that we face may cause our business and financial results to suffer. We believe that the primary competitive factors determining success in these markets include effective marketing to promote brand awareness, a reputation for reliability and service, effective customer support, pricing, easy-to-use software and geographic coverage. Other important factors include the timing and introduction of new products and services and industry and general economic trends. We expect competition to continue to increase because the markets in which we operate face few substantial barriers to entry. Competition may also intensify as a result of industry consolidation and the ability of some of our competitors to bundle Internet services with other products and services. Our current and potential competitors include many large national companies that have substantially greater market presence and financial, technical, distribution, marketing and other resources than we have. This may allow them to devote greater resources than we can to the development, promotion and distribution and sale of products and services. Additionally, our competitors may be able to charge less for premium Internet services than we do for our billable premium services, or offer services for free that we currently provide only for a fee, which may put pressure on us to reduce or eliminate, or prevent us from raising, the fees we charge for our billable premium services. We may choose to lower or eliminate the fees we currently charge for our billable premium services, or enhance the features available to users of our free basic service, in order to remain competitive with other industry participants. If we do so, our business and financial results may suffer. In recruiting subscribers for our services, we currently compete, or expect to compete, with the following types of companies, among others: - Established online service providers such as America Online, CompuServe, and The Microsoft Network; - Independent national Internet service providers such as EarthLink, MindSpring, and Prodigy, including a number of companies, such as AltaVista and NetZero, that offer Web access for free; - Numerous independent regional and local Internet service providers that may offer lower prices than a national Internet service provider; - Various national and local telephone companies such as AT&T, MCI WorldCom and Pacific Bell; - Companies providing Internet access through "set-top boxes" connected to a user's television, such as WebTV, or through a "cable modem" connected to a user's personal computer, such as Excite@Home; and - Companies providing Internet access services using other broadband technologies, including digital subscriber line technology, commonly known as DSL, such as the Regional Bell Operating Companies and various partners of Covad, Rhythms, and NorthPoint. In addition, Microsoft and Netscape, publishers of the Web browsers utilized by most Internet users, including Juno subscribers, each own or are owned by online or Internet service providers that compete with Juno. In addition to competition from the types of companies listed above, we also face the risk that subscribers to our premium billable services will migrate to our free basic service, which would result in a decrease in our subscription revenues. We do not currently compete internationally. If the ability to provide Internet services internationally becomes a competitive advantage in our markets and we do not begin to provide services internationally, we will be at a competitive disadvantage. WE RELY ON REVENUES FROM ADVERTISING AND ELECTRONIC COMMERCE With respect to the generation of advertising revenue, we compete with many of the market participants listed above as well as with various advertising-supported Web sites, including portal sites such as Yahoo! and Excite, content sites such as CNET and CNN.com, and interactive advertising networks and agencies such as DoubleClick and 24/7 Media. We also compete with traditional media such as print and television for a share of advertisers' total advertising budgets. If advertisers perceive the Internet to be a limited or ineffective advertising medium or perceive us to be less effective or less desirable than other Internet advertising vehicles, advertisers may be reluctant to advertise on our services. Please see "--Our business may be adversely affected if the market for Internet advertising fails to develop" for more information regarding our advertising activities. We engage in electronic commerce activities by selling or facilitating the sale of products and services directly to our subscribers. In doing so, we compete with other Internet-based merchants as well as with stores and other companies that do not distribute their products through the Internet. Many of these competitors are larger than we are, enjoy greater economies of scale than are available to us, have substantially greater resources than we have, and may be able to offer more products or more attractive prices than we can. We believe that this competition is likely to increase in the future. OUR COMPETITION IS LIKELY TO INCREASE IN THE FUTURE Our competition is likely to increase. We believe this will probably happen as Internet service providers and online service providers consolidate and become larger, more competitive companies, and as large diversified telecommunications and media companies acquire Internet service providers. Other Internet service providers are likely to begin offering free Internet access. Since our announcement of free Internet access in December 1999, at least one competitor has announced the introduction of a service similar to ours. The larger Internet service providers and online service providers, including America Online, offer their subscribers a number of services that we do not currently provide. Some diversified telecommunications and media companies, such as AT&T, have begun to bundle other services and products with Internet access services, potentially placing us at a significant competitive disadvantage. Additionally, some Internet service providers and personal computer manufacturers have formed strategic alliances to offer free or deeply discounted computers to consumers who agree to sign up with the service provider for a one-year or multi-year term. In a variant on this approach, some Internet service providers have secured strategic relationships with manufacturers or retailers of computer equipment in which the service provider finances a rebate to consumers who sign up with the service provider for one or more years. We have formed several such relationships, and have not found them effective as a means of attracting new subscribers to our services. There can be no assurance that any of the relationships we have formed will be successful as a means of attracting new subscribers, that they will be economically favorable, or that the terms of these relationships, or any strategic alliances we complete in the future, will turn out to be as favorable as those achieved by our competitors or favorable at all. Our competitors may be able to establish strategic alliances or form joint ventures that put us at a serious competitive disadvantage. Competition could require us to increase our spending for sales and marketing as well as for subscriber acquisition in order to maintain our position in the marketplace, and could also result in increased subscriber attrition. Competition could also require us to lower the prices we charge for our billable premium services, or eliminate such fees altogether, in order to maintain our marketplace position. Any of these scenarios could harm our business and financial results, and we may not have the resources to continue to compete successfully. WE ARE DEPENDENT ON STRATEGIC MARKETING ALLIANCES AS A SOURCE OF REVENUES AND OUR BUSINESS COULD SUFFER IF ANY OF THESE ALLIANCES ARE TERMINATED We have strategic marketing alliances with a number of third parties, and most of our strategic marketing partners have the right to terminate their agreements with us on short notice. In the past year, one strategic marketing partner terminated a multi-year agreement at the end of its first year. If any of our strategic marketing agreements are terminated, we cannot assure you that we will be able to replace the terminated agreement with an equally beneficial arrangement. We also expect that we will not be able to renew all of our current agreements when they expire or, if we are, that we will be able to do so on acceptable terms. We also do not know whether we will be successful in entering into additional strategic marketing alliances, or that any additional relationships, if entered into, will be on terms favorable to us. Our receipt of revenues from our strategic marketing alliances may also be dependent on factors which are beyond our control, such as the quality of the products or services offered by our strategic marketing partners. WE MUST ADAPT TO TECHNOLOGY TRENDS AND EVOLVING INDUSTRY STANDARDS OR WE WILL NOT BE COMPETITIVE Our failure to respond in a timely and effective manner to new and evolving technologies, including cable modem and other broadband technology, could harm our business and financial results. The Internet services market is characterized by rapidly changing technology, evolving industry standards, changes in member needs and frequent new service and product introductions. Our business and financial results depend, in part, on our ability to use leading technologies effectively, to develop our technical expertise, to enhance our existing services and to develop new services that meet changing member needs on a timely and cost-effective basis. In particular, we must provide subscribers with the appropriate products, services and guidance required to best take advantage of the rapidly evolving Internet. If the market for our services should fail to develop, develop more slowly than we expect, become saturated with competitors, or develop in a fashion that renders our services uncompetitive or otherwise unappealing to consumers, our business and financial results may suffer. We are also at risk due to fundamental changes in the way that Internet access may be provided in the future. Currently, consumers access Internet services primarily through computers connected by telephone lines. Broadband connections, however, allow significantly faster access to the Internet than is possible using the telephone-based analog modems currently used by most of our subscribers. The companies currently providing or expecting to begin providing broadband connections to consumers' homes, including cable television companies, local and long distance telephone companies, electric utility companies and wireless communications companies, have decided or may decide to provide Internet access as well. For example, competitors have developed technologies that enable cable television operators to offer high-speed Internet access through their cable facilities. These cable television operators, as well as other competitors, may include Internet access in their basic bundle of services or may offer Internet access for a nominal additional charge. Moreover, these companies could prevent us in the future from delivering Internet access through the wire and cable connections that they own, or from doing so on a cost-effective basis. Even if we are not prevented from delivering our Internet services through the broadband connections owned by other companies, the delivery of our Internet services using broadband technology is subject to significant risks and uncertainties, and we may be unable to adapt to the challenges posed by broadband technologies. Please see "--If the market for broadband access in general, or for Juno Express in particular, fails to develop, or if other broadband technologies prove more popular than DSL, our business may be harmed." We may also have to modify the means by which we deliver our Internet services, in which case we would incur significant costs. If consumers adopt alternative forms of Internet access that provide a continuous connection to the Internet rather than relying on a series of separate dial-up connections, then any competitive advantage that we currently realize because our technology minimizes connect time may diminish. If other companies are able to prevent us from delivering our Internet services through the wire, cable and wireless connections that they own, if we are unable to adapt to the challenges posed by broadband technologies or if we incur significant costs without generating sufficient revenues, our business and financial results may suffer. IF THE MARKET FOR BROADBAND ACCESS IN GENERAL, OR FOR JUNO EXPRESS IN PARTICULAR, FAILS TO DEVELOP, OR IF OTHER BROADBAND TECHNOLOGIES PROVE MORE POPULAR THAN DSL, OUR BUSINESS MAY BE HARMED We recently launched a small-scale pilot test of Juno Express, a premium billable service which delivers Internet access at broadband speeds through the use of DSL technology. As the Juno Express service is currently designed, before we can provide DSL-based service to a subscriber, the subscriber's local telephone company must either install and configure an additional copper telephone line at the subscriber's residence or reconfigure an existing telephone line if a line that can be dedicated exclusively to the DSL connection is available. Accordingly, consumers who wish to subscribe to Juno Express currently must go through a complex installation process, for which we are dependent on the performance of the local telephone company. We are also currently dependent on the performance of a national supplier of DSL services, Covad Communications, with whom we have chosen to partner for the delivery of Juno Express. Covad is responsible for completing the installation process begun by the local telephone company. Currently, a Covad technician must visit the residence of each Juno Express subscriber to complete any necessary wiring and to deliver and test DSL hardware. If our relationship with Covad is unsuccessful, or if Juno and Covad are unable to coordinate the installation of necessary telephone lines with local telephone companies, or if other factors delay or otherwise hinder our ability to complete the roll-out of Juno Express into additional markets beyond those involved in the pilot test, or if these or other factors affect our ability to introduce or deliver broadband services in a timely and cost-effective fashion, then our business and financial results may suffer. The market for broadband services is in the early stages of development, and we cannot assure you that DSL technology in particular or broadband services in general will become popular with consumers. If alternate broadband delivery technologies, such as cable or wireless technologies, become more popular with consumers than DSL, we cannot assure you we will be able to gain access to such alternate technologies at favorable rates or at all. Additionally, Juno Express faces competition in the market for broadband services from many competitors with significant financial resources, well-established brand names, and large existing customer bases. Many local telephone companies are themselves in some stage of test marketing or offering broadband services. In many markets, these competitors already offer, or are expected to offer, broadband Internet access at prices lower than we expect to be able to offer to potential customers for Juno Express. If we are unable to provide competitive broadband services at competitive rates, our business and financial results may suffer. OUR BUSINESS MAY BE ADVERSELY AFFECTED IF THE MARKET FOR INTERNET ADVERTISING FAILS TO DEVELOP Our business and financial results are dependent on the use of the Internet as an advertising medium. Internet-based advertising accounts for only a small fraction of all advertising expenditures, and we cannot be sure that Internet-based advertising will ever grow to account for a substantial percentage of total advertising spending or when an increase might occur. Our business may suffer if the market for Internet-based advertising fails to develop or develops more slowly than expected. In addition, no standards have been widely accepted to measure the effectiveness of Internet-based advertising. If measurement standards do not develop, many advertisers may choose not to advertise on the Internet. Different pricing models are used to sell Internet-based advertising. Our revenues could suffer if we are unable to adapt to new forms of, and new pricing models for, Internet-based advertising. It is difficult to predict which, if any, forms of Internet-based advertising will emerge as the industry standard. This makes it difficult to project our future advertising rates and revenues. Moreover, "filter" software programs that limit or prevent advertising from being delivered to an Internet user's computer are available. Widespread adoption of this type of software could harm the commercial viability of Internet-based advertising. Sales of advertising space on our services represent an important revenue source for us. Our expansion of our free basic service to include Web access may increase our dependence on advertising revenues. Competition for Internet-based advertising revenues is intense, and this competition could result in significant price erosion over time. We cannot assure you that we will be successful in selling advertising or capturing a significant share of the market for Internet-based advertising. We also cannot assure you that we will be able to sell advertising at the rates we currently project. It is also possible that we will find it necessary to lower the rates for advertising space on our services. Please see "--The expansion of our free basic service to include Web access increases our telecommunications costs and exposes us to additional business risks." We currently rely on our internal sales and marketing personnel for generating sales leads and promoting our services to the advertising community. With substantially all of our sales and marketing personnel based in New York City, we may not be able to effectively market our services to regional advertisers outside of New York. We also rely on the sales and marketing personnel of Lycos, our primary Web site content partner, for the sale of advertising space on the default portal site used by Juno Web subscribers. Although we have not done so in the past, we might also retain the services of one or more external sales organizations to sell advertising space on our network. We cannot be sure that our internal sales organization, Lycos or any other independent sales organization will achieve our advertising sales objectives in a cost-effective manner. If Internet-based advertising does not continue to grow, if we are unable to capture a sufficient share of Internet-based advertising, or if Lycos or other independent sales organizations do not perform as we anticipate, our business and financial results may suffer. OUR ADVERTISING SYSTEM REQUIRES LABOR AND IMPOSES COSTS ON US BEYOND THOSE ASSOCIATED WITH STANDARD WEB ADVERTISING Some of the advertising inventory available on our services is non-standard when compared to advertising on the Web and may put Juno at a competitive disadvantage. The advertisements displayed while a subscriber reads and writes e-mail are created using proprietary tools that are not fully compatible with standard Web advertising. Therefore, many advertisements displayed on our services require customization that would not be required by a Web site capable of displaying previously prepared standard advertisements. This customization work increases the time necessary to prepare an advertisement to be displayed on our services and the costs associated with running these ads. We must also absorb the telecommunications cost associated with initially downloading these ads to our subscribers, which is an expense that advertising-supported Web sites do not incur. As ads become more complex, our telecommunications expenses may increase. Furthermore, the costs associated with selling or attempting to sell advertising space on our services are significant. These costs may be greater than the costs associated with selling advertising space on Web sites that exclusively utilize standard Web advertising formats. Additionally, our use of a proprietary advertising format could prevent us from packaging a significant portion of our advertising space for sale by an advertising network such as DoubleClick. We also rely on detailed data provided by our subscribers for purposes of targeting some ads. We do not currently verify the accuracy of this data at the time it is provided or require subscribers to update their information thereafter. Furthermore, individuals who subscribe directly to one of our billable premium services are not currently required to provide this data. Any of the above factors could discourage advertising on our network by some advertisers. SEASONAL TRENDS IN INTERNET USAGE AND ADVERTISING SALES MAY NEGATIVELY AFFECT OUR BUSINESS Seasonal trends are likely to affect the revenues we generate from operating our Internet services. Subscribers typically use our Internet services less during the summer months and year-end holiday periods. To the extent that our revenues depend on the amount of usage by our subscribers, our revenues may be lower during these periods. For example, some of the subscribers to Juno Web pay us based on the number of hours they spend using our services in a given month. In addition, the rate at which new subscribers sign up for our billable premium services may be lower during the summer months and year-end holiday periods. Since our operating expenses are based on our expectations of future revenues, including seasonal fluctuations, it is possible that operating results will suffer if these seasonal trends do not continue in the future or if different seasonal trends develop in the future. Please see "Management's Discussion and Analysis of Financial Condition and Results of Operations" for more information on our operating results. WE ARE DEPENDENT ON A SMALL NUMBER OF TELECOMMUNICATIONS CARRIERS AND MAY BE UNABLE TO FIND ADEQUATE REPLACEMENTS IF THEIR RATES INCREASE, SERVICE QUALITY DECLINES, OR IF THEY DISCONTINUE DOING BUSINESS WITH US Our business and financial results depend in significant part on the capacity, affordability, reliability and security of our telephone company data networks. To use our services, subscribers must initiate telephone connections between their personal computers and computer hardware in local or regional facilities known as "points of presence." We contract for the use of points of presence around the country from various telecommunications carriers. These carriers currently include UUNET Technologies and WorldCom Advanced Networks, both of which are operated by MCI WorldCom; Level 3; Concentric; Splitrock Services; and Sprint. These telecommunications companies also carry data between their points of presence and our central computers located in Cambridge, Massachusetts and Jersey City, New Jersey. As of December 31, 1999, we had contracted for the use of more than 2,300 local telephone numbers associated with points of presence throughout the United States. Nevertheless, a significant minority of our subscriber base is unable to access our services through a point of presence that is within their local calling area. These users may be particularly reluctant to use the Web, either through our free basic service or through Juno Web, due to the telecommunications charges that they would incur during an extended connection to the Web. The inability of some of our subscribers to access the Web with a local call in some areas of the country could harm our business. We cannot be sure if or when additional infrastructure developments by our telecommunications providers will establish points of presence that cover these areas. At various times in the past, network capacity constraints at particular points of presence have prevented or delayed access by subscribers attempting to connect to our services. This could happen in the future, especially during times of peak usage. Difficulties accessing our services due to poor network performance could cause our subscribers to terminate their membership with us. Because we depend on third-party telecommunications carriers for crucial portions of our network infrastructure, we do not have direct control over network reliability and some aspects of service quality. A natural disaster or other unanticipated problem that affects the points of presence or the telecommunications lines we use, or that affects the nation's telecommunications network in general, could cause interruptions in our services. Only a small number of telecommunications companies can provide the network services we require. This number has been reduced through consolidation in the telecommunications industry, and there is a significant risk that further consolidation could make us reliant on an even smaller number of providers. Currently, we are particularly dependent on companies controlled by MCI WorldCom, which provide more than 1,100 of the more than 2,300 points of presence for which we contract in the United States, and which carry a significant percentage of our traffic. Furthermore, MCI WorldCom has announced that it will offer consumer Internet access, making it a direct competitor of ours. Additionally, MCI WorldCom has announced that it will merge with Sprint during 2000, subject to approval of their stockholders and the receipt of regulatory approvals. This merger will further concentrate our reliance on MCI WorldCom and the companies it controls. Our business could be significantly harmed if we are unable to maintain a favorable relationship with MCI WorldCom. We cannot assure you that we would be able to replace the services provided to us by MCI WorldCom were our relationship with them to be terminated. Our financial results are highly sensitive to variations in prices for the telecommunications services described above. We cannot assure you that telecommunications prices will decline, or that there will not be telecommunications price increases due to factors beyond our control. Some of our telecommunications carriers impose minimum connection charges. Our business could be harmed if minimum connection charges increase or become more prevalent. We cannot assure you that our telecommunications carriers will continue to provide us access to their points of presence on adequate price terms, or that alternative services will be available in the event that their quality of service declines or that our relationship with any of our current carriers is terminated. Most of the telecommunications services we purchase are provided to us under short-term agreements that the providers can terminate or elect not to renew. As a result, there is a significant risk that any or all of UUNET Technologies, WorldCom Advanced Networks, Level 3, Concentric, Splitrock or Sprint could end their relationship with us. In addition, each of our telecommunications carriers provides network access to some of our competitors, and could choose to grant those competitors preferential network access, potentially limiting our members' ability to access the Internet or connect to our central computers. Furthermore, the majority of our telecommunications providers compete, or have announced an intention to compete, with us in the market to provide consumer Internet access. If our telecommunications service providers were to decrease the levels of service or access provided to us, or if they were to terminate their relationships with us for competitive or other reasons, our business and financial results would suffer. THE ECONOMIC VIABILITY OF OUR EXPANDED FREE BASIC SERVICE MAY DEPEND ON OUR ABILITY TO OBTAIN TELECOMMUNICATIONS CAPACITY ON A FIXED-PRICE BASIS We believe that our ability to purchase telecommunications capacity from our network providers on a fixed-price basis may be a critical component of our ability to cost-effectively provide full Internet access for free. We currently purchase most of the telecommunications capacity we use on a variable-price basis. Under this variable pricing model, we share points of presence with other Internet access providers and are charged at a specified rate for every minute during which a Juno subscriber is connected to one of our network providers' modems. We have no control over how many modems are available at any given time for our subscribers' use or over the ratio of Juno subscribers to available modems. We believe we may be able to lower our monthly per-subscriber telecommunications cost by purchasing telecommunications capacity on a per-modem basis and by maintaining a higher ratio of subscribers to modems than is typical in the industry. We have recently begun to experiment with this fixed-price model. However, there are a number of risks and uncertainties related to this pricing model. Under this fixed-price model, we contract for exclusive use of a certain number of modems and are charged the same amount regardless of the amount of data actually transmitted over the modems during a month. The effective per-subscriber costs incurred under this model are highly sensitive to our ability to accurately project, as much as six months in advance, our rate of subscriber growth and the level of usage per subscriber. If we overestimate and commit to lease too many modems, our per-subscriber costs will increase, possibly significantly. If we underestimate and lease too few modems to satisfy the levels of subscriber demand we actually experience, service quality and customer satisfaction may suffer. We cannot assure you that we will be able to effectively project our telecommunications capacity requirements or otherwise manage these telecommunications relationships. We have entered into only one agreement under which we purchase telecommunications capacity on a per-modem basis. This agreement is with a supplier that, as of December 1999, operated in a limited number of geographic markets, corresponding to at most one-third of our subscriber base. As of that date, fewer than half of our subscribers within these geographic markets had connected to modems being made available to us under a per-modem pricing model. In order to secure exclusive use of the modems we have leased from this supplier, we have been required to make advance commitments totaling approximately $13.3 million for telecommunications capacity. Our agreement provides us only limited rights to demand additional capacity from this supplier. If we are unsuccessful in contracting with additional suppliers to provide us with per-modem pricing, if our current supplier is unable or unwilling to accommodate our expansion, or if we are unable to accurately project our telecommunications needs, our business and financial results may suffer. WE ARE DEPENDENT ON THIRD PARTIES FOR TECHNICAL AND CUSTOMER SERVICE SUPPORT AND OUR BUSINESS MAY SUFFER IF THEY ARE UNABLE TO PROVIDE THESE SERVICES OR CANNOT EXPAND TO MEET OUR NEEDS Our business and financial results depend, in part, on the availability of live technical and customer service support, and of inbound telemarketing and disk distribution services. Should our ability to provide these services be hampered, our business may suffer. Although many Internet service providers have developed internal customer service operations designed to meet these needs, we have elected to outsource these functions to third-party vendors. We currently use ClientLogic Corporation for technical and customer service support. As a result, we maintain only a small number of internal customer service personnel. We are not equipped to provide the necessary range of customer service and telemarketing services in the event that either ClientLogic or other external providers become unable or unwilling to offer these services to us. Our most important relationship is with ClientLogic, which, at December 31, 1999, provided us with approximately 430 full-time or part-time employees at its facilities to service our account. The availability of call-in technical support and customer service is especially important to acquire and retain subscribers to our billable premium services, and we rely almost entirely on ClientLogic to provide this function. At times, our subscribers have experienced lengthy waiting periods to reach representatives trained to provide the technical or customer support they require. The growth of our subscriber base has caused waiting periods for technical and customer support to lengthen recently. Reducing these waiting periods and accommodating potential future growth will require significantly more support personnel than are currently available to us through ClientLogic. Additionally, if we elect to offer customer service features that we do not currently support, such as 24-hour live support, or to enhance the overall quality of our customer support for competitive reasons, we will require even greater resources. As a result, we expect that it will become necessary, in the near future, to identify supplemental or replacement vendors for these services or to develop the resources ourselves to deliver these services. Our agreement with ClientLogic converts to a month-to-month contract on August 1, 2000, providing either party the right to terminate the relationship at any time upon one month's notice. Prior to that date, ClientLogic can terminate the contract without cause upon 90 days notice. In addition, ClientLogic may terminate the contract upon 60 days notice if we do not reach agreement with ClientLogic with regard to modifications ClientLogic proposes to the pricing terms of the contract within 60 days of the modifications being proposed. If our relationship with ClientLogic terminates and we are unable to enter into a comparable arrangement with a replacement vendor, if ClientLogic is unable to provide enough personnel to provide the quality and quantity of service we desire, if system failures, outages or other technical problems make it difficult for our subscribers to reach customer service representatives at ClientLogic, or if we are required to obtain externally or develop internally additional or replacement customer service and technical support capacity, our business and financial results may suffer. DISRUPTION OF OUR INTERNET SERVICES DUE TO SECURITY BREACHES AND SYSTEM FAILURES COULD RESULT IN SUBSCRIBER CANCELLATIONS Both our infrastructure and the infrastructure of our network providers are vulnerable to security breaches or similar disruptive problems and system failures. Our systems are also subject to telecommunications failures, power loss, software-related system failures and various other events. Any of these events, whether intentional or accidental, could lead to interruptions, delays or cessation of service to our subscribers. This could cause some of our subscribers to stop using our Internet services. Third parties could also potentially jeopardize the security of confidential information stored in our computer systems or our subscribers' computer systems through their inappropriate use of the Internet, which could cause losses to us or our subscribers or deter some people from subscribing to our services. People may be able to circumvent our security measures or the security measures of our third party network providers. We may have to interrupt, delay or cease service to our subscribers to alleviate problems caused by computer viruses, security breaches or other failures of network security. Any damage or failure that interrupts or delays our operations could result in subscriber cancellations, could harm our reputation, and could affect our business and financial results. In addition, we expect that our subscribers will increasingly use the Internet for commercial transactions in the future. Any network malfunction or security breach could cause these transactions to be delayed, not completed at all or completed with compromised security. Our subscribers or others may assert claims of liability against us as a result of this type of failure. Furthermore, until more comprehensive security technologies are developed, the security and privacy concerns of existing and potential subscribers may inhibit the growth of the Internet service industry in general and our subscriber base and revenue in particular. Our insurance policies may not adequately compensate us for any losses that may occur due to any failures in our systems or interruptions in our services. RAPID GROWTH IN OUR BUSINESS COULD STRAIN OUR MANAGERIAL, OPERATIONAL, FINANCIAL, AND INFORMATION SYSTEMS RESOURCES The anticipated future growth necessary to expand our operations will place a significant strain on our managerial, operational, financial and information systems resources. If we are unable to manage our growth effectively, our business and financial results will suffer. In order to achieve growth in revenues from Internet advertising, we will need to expand our sales efforts and continue to improve and develop our software. In order to achieve growth in revenues from our billable premium services, we will need to expand our marketing efforts, promote the Juno brand, expand the computer systems and related infrastructure we use to provide our Internet services, and increase both our internal and outsourced customer service capabilities. We expect that we will need to continually improve our financial and managerial controls, billing systems, reporting systems and procedures, and we will also need to continue to expand, train and manage our workforce. We had 65 employees at December 31, 1996, 152 employees at December 31, 1997, 144 employees at December 31, 1998 and 263 employees at December 31, 1999, including 60 employees in India. Prior to May 21, 1999, consultants used in India were employed by an affiliate of Juno. We have significantly increased our reliance on outsourced support for customer service, technical, and back-office functions. We expect the size of our own workforce and our reliance on outsourced services will continue to increase for the foreseeable future. The demand on our network infrastructure, technical staff and technical resources has grown rapidly with our expanding subscriber base. We cannot be certain that our infrastructure, technical staff and technical resources will adequately accommodate or facilitate the anticipated growth of our subscriber base. In particular, if we were to experience repeated or prolonged system-wide service outages, our business and financial results would suffer. WE FACE POTENTIAL LIABILITY FOR INFORMATION TRANSMITTED OR RETRIEVED THROUGH OUR INTERNET SERVICES Our business and financial results may suffer if we incur liability as a result of information transmitted or retrieved through our services. The liability of Internet service providers and online services companies for information transmitted or retrieved through their services is uncertain. It is possible that claims may be filed against us based on a variety of theories, including defamation, obscenity, negligence, copyright or trademark infringement, or other theories based on the nature, publication or distribution of this information. These types of claims have been brought, sometimes successfully, against providers of Internet services in the past. Such claims, with or without merit, would likely divert management time and attention and result in significant costs to investigate and defend. In addition, if we become subject to these types of claims and we are not successful in our defense, we may be forced to pay substantial damages. We may also be forced to implement expensive measures to alter the way our services are provided to avoid any potential liability. CHANGES IN GOVERNMENT REGULATION COULD DECREASE OUR REVENUES AND INCREASE OUR COSTS Changes in the regulatory environment could decrease our revenues and increase our costs. As a provider of Internet access and e-mail services, we are not currently subject to direct regulation by the Federal Communications Commission. However, several telecommunications carriers are seeking to have communications over the Internet regulated by the FCC in the same manner as other more traditional telecommunications services. Local telephone carriers have also petitioned the FCC to regulate Internet access providers in a manner similar to long distance telephone carriers and to impose access fees on these providers, and recent events suggest that they may be successful in obtaining the treatment they seek. In addition, we operate our services throughout the United States, and regulatory authorities at the state level may seek to regulate aspects of our activities as telecommunications services. As a result, we could become subject to FCC and state regulation as Internet services and telecommunications services converge. We remain subject to numerous additional laws and regulations that could affect our business. Because of the Internet's popularity and increasing use, new laws and regulations with respect to the Internet are becoming more prevalent. These laws and regulations have covered, or may cover in the future, issues such as: - user privacy; - pricing; - intellectual property; - federal, state and local taxation; - distribution; and - characteristics and quality of products and services. Legislation in these areas could slow the growth in use of the Internet generally and decrease the acceptance of the Internet as a communications and commercial medium. Additionally, because we rely on the collection and use of personal data from our subscribers for targeting advertisements shown on our services, we may be harmed by any laws or regulations that restrict our ability to collect or use this data. The Federal Trade Commission has begun investigations into the privacy practices of companies that collect information about individuals on the Internet. In addition, the FTC is conducting an ongoing investigation into the marketing practices of Internet-related companies, including Juno. As part of the FTC's activities, we have been requested to provide, and have provided, marketing-related and customer service-related information to the FTC. Depending on the outcome of the FTC inquiry, we could be required to modify our marketing or customer service practices in a way that could negatively affect our business. It may take years to determine how existing laws such as those governing intellectual property, privacy, libel and taxation apply to the Internet. Any new legislation or regulation regarding the Internet, or the application of existing laws and regulations to the Internet, could harm us. Additionally, while we do not currently operate outside of the United States, the international regulatory environment relating to the Internet market could have an adverse effect on our business, especially if we should expand internationally. The growth of the Internet, coupled with publicity regarding Internet fraud, may also lead to the enactment of more stringent consumer protection laws. For example, numerous bills have been presented to Congress and various state legislatures designed to address the prevalence of unsolicited commercial bulk e-mail on the Internet. These laws may impose additional burdens on our business. The enactment of any additional laws or regulations in this area may impede the growth of the Internet, which could decrease our potential revenues or otherwise cause our business to suffer. Please see "Business--Government Regulation." IF INTERNET USAGE DOES NOT CONTINUE TO GROW, OUR BUSINESS WILL SUFFER Our business and financial results depend on continued growth in the use of the Internet. We cannot be certain that this growth will continue or that it will continue in its present form. If Internet usage declines or evolves away from our business, our growth will slow or stop and our business and financial results will suffer. UNANTICIPATED DELAYS OR PROBLEMS IN THE INTRODUCTION OF NEW FEATURES OR SERVICES MAY CAUSE CUSTOMER DISSATISFACTION If we experience problems related to the reliability and quality of our services or delays in the introduction of new versions of or enhancements to our services, we could experience increased subscriber cancellations, adverse publicity and reduced sales of advertising and products. Our services are very complex and are likely to contain a number of undetected errors and defects, especially when new features or enhancements are first released. Furthermore, in order to introduce new features or enhancements, we may elect to license technology from other companies rather than develop such features or enhancements ourselves, and we may be exposed to undetected errors or defects in third-party technology that is out of our control. Any errors or defects, if significant, could harm the performance of these services, result in ongoing redevelopment and maintenance costs and cause dissatisfaction on the part of subscribers and advertisers. These costs, delays or dissatisfaction could negatively affect our business. WE HAVE LIMITED EXPERIENCE WITH THE SOFTWARE WE USE TO BILL SUBSCRIBERS TO OUR BILLABLE PREMIUM SERVICES The operation of our billable premium services requires the accurate operation of billing system software as well as our development of policies designed to reduce the incidence of credit card fraud and other forms of uncollectable "chargebacks." We have limited experience with the operation of these billing and fraud detection systems. If we encounter difficulty with the operation of these systems, or if errors, defects or malfunctions occur in the operation of these systems, this could result in erroneous overcharges to customers or in the under-collection of revenue, either of which could hurt our business and financial results. OUR RELATIONSHIP WITH D. E. SHAW & CO., L.P. MAY PRESENT POTENTIAL CONFLICTS OF INTEREST The Chairman of our board of directors and our controlling stockholder, Dr. David E. Shaw, is the Chairman and Chief Executive Officer of D. E. Shaw & Co., Inc., which is the general partner of D. E. Shaw & Co., L.P., a global securities firm whose activities focus on various aspects of the intersection between technology and finance. Dr. Shaw devotes only a portion of his time to our company, and spends most of his time and energy engaged in business activities unrelated to us. Dr. Shaw indirectly owns a controlling interest in DESCO, L.P. and in some of its affiliated entities. Transactions between us and these parties may occur in the future and could potentially result in conflicts of interest that prove harmful to us. In the past, we have contracted with DESCO, L.P. to provide accounting, tax, payroll, insurance, employee benefits and information technology services to us, and we may obtain these or other services from DESCO, L.P. in the future. At the current time, we sublease office space in New York City from DESCO, L.P. We cannot be sure that we would be able to lease other space on favorable terms in the event this sublease were to be terminated. In May 1999, we terminated an agreement with DESCO, L.P. under which individuals employed by its affiliates located in India provided consulting services to us. Following the termination of this agreement, these individuals became employees of a Juno subsidiary located in Hyderabad, India. We expect to continue to obtain some services in India from DESCO, L.P. or its affiliates. Dr. Shaw and entities affiliated with him are likely to manage, invest in or otherwise be involved with other technology-related business ventures apart from our company. These relationships could also restrict our ability to transact business with non-affiliated parties, and could negatively affect us. For a more detailed discussion of related-party transactions and our relationship with entities affiliated with Dr. Shaw, please see "Certain Transactions." OUR DIRECTORS AND OFFICERS WILL EXERCISE SIGNIFICANT CONTROL OVER US FOLLOWING THIS OFFERING As of January 31, 2000, the executive officers, directors, and persons and entities affiliated with executive officers or directors beneficially owned in the aggregate approximately 50.4% of our outstanding common stock. We anticipate that the executive officers, directors and persons and entities affiliated with executive officers or directors will, in the aggregate, beneficially own approximately 46.1% of our outstanding common stock following the completion of this offering. The Chairman of our board of directors is Dr. David E. Shaw. Dr. Shaw continues to serve as the Chairman and Chief Executive Officer of D. E. Shaw & Co., Inc., which is the general partner of DESCO, L.P. Dr. Shaw and persons or entities affiliated with him, including DESCO, L.P., will, in the aggregate, beneficially own approximately 44.6% of our outstanding common stock following the completion of this offering. As a result of this concentration of ownership, Dr. Shaw is able to exercise significant influence over matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions. This concentration of ownership could also have the effect of delaying or preventing a change in control of Juno. Please see "Management" and "Principal Stockholders." IF WE FAIL TO ADEQUATELY PROTECT OUR INTELLECTUAL PROPERTY OR FACE A CLAIM OF INTELLECTUAL PROPERTY INFRINGEMENT BY A THIRD PARTY, WE COULD LOSE OUR INTELLECTUAL PROPERTY RIGHTS OR BE LIABLE FOR SIGNIFICANT DAMAGES We have taken steps to protect our intellectual property rights, but we cannot be certain that our efforts will be adequate to safeguard our rights to technology we have developed. Disputes concerning the ownership or rights to use intellectual property could be costly and time consuming to litigate, may distract management from other tasks of operating the business, and may result in our loss of significant rights and the loss of our ability to operate our business. We have been granted three U.S. patents covering aspects of our technology for the offline display of advertisements and the authentication and dynamic scheduling of advertisements and other messages to be delivered to computer users. We have also filed a number of other U.S. patent applications relating to additional aspects of our business. We cannot assure you, however, that these applications will result in the issuance of patents, that any patents that have been granted or that might be granted in the future will provide us with any competitive advantages or will be exploited profitably by us, or that any of these patents will withstand any challenges by third parties. We also cannot assure you that others will not obtain and assert patents against us which are essential for our business. If patents are asserted against us, we cannot assure you that we will be able to obtain license rights to those patents on reasonable terms or at all. If we are unable to obtain licenses, we may be prevented from operating our business and our financial results may therefore be harmed. Except as described above, we rely solely upon copyright and trademark law, trade secret protection and confidentiality agreements with our employees and with some third parties to protect our proprietary technology, processes, and other intellectual property, to the extent that protection is sought or secured at all. We cannot assure you that any steps we might take will be adequate to protect against infringement and misappropriation of our intellectual property by third parties. Similarly, we cannot assure you that third parties will not be able to independently develop similar or superior technology, processes, or other intellectual property. Furthermore, we cannot assure you that third parties will not assert claims against us for infringement and misappropriation of their intellectual property rights nor that others will not infringe or misappropriate our intellectual property rights, for which we may wish to assert claims. PROBLEMS RESULTING FROM THE YEAR 2000 PROBLEM COULD REQUIRE US TO INCUR UNANTICIPATED EXPENSE AND COULD DIVERT MANAGEMENT'S TIME AND ATTENTION The Year 2000 problem could harm our business and financial results. Many currently installed computer systems and software products produced before January 1, 2000 were coded to accept or recognize only two-digit entries in the date code field. These systems may interpret the date code "00" as the year 1900 rather than the year 2000. As a result, computer systems and software used by many companies and governmental agencies may need to be upgraded or replaced to comply with Year 2000 requirements or risk system failure or miscalculations causing disruptions of normal business activities. We are not aware of any material Year 2000 problems that have harmed or threaten to harm our business, but we cannot assure you that no such problems will emerge. Our failure to correct a material Year 2000 problem could result in an interruption in, or a failure of, aspects of our normal business activities or operations. In addition, a significant Year 2000 problem involving our network services or equipment provided to us by third-party vendors could cause our customers to consider seeking alternate providers or cause an unmanageable burden on our customer service and technical support capabilities. Any significant Year 2000 problem could require us to incur significant unanticipated expenses to remedy these problems and could divert management's time and attention. Please see "Management's Discussion and Analysis of Financial Condition and Results of Operations--Impact of the Year 2000" for more detailed information regarding the Year 2000 issue. WE ARE DEPENDENT ON KEY MANAGEMENT PERSONNEL FOR OUR FUTURE SUCCESS Our business and financial results depend in part on the continued service of our key personnel. We do not carry key person life insurance on any of our personnel. The loss of the services of any of our executive officers or the loss of the services of other key employees could harm our business and financial results. WE MAY NOT BE ABLE TO HIRE AND RETAIN QUALIFIED EMPLOYEES Our business and financial results depend in part on our ability to attract, retain and motivate highly skilled employees. Competition for employees in our industry is intense, and has become more pronounced recently. We may be unable to retain our key employees or attract, assimilate or retain other highly qualified employees. We have from time to time in the past experienced, and we expect to continue to experience, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. WE CANNOT PREDICT OUR FUTURE CAPITAL NEEDS AND WE MAY NOT BE ABLE TO SECURE ADDITIONAL FINANCING We currently anticipate that the net proceeds of this offering, together with available funds, will be sufficient to meet our anticipated needs for at least the next 12 months. We may need to raise additional funds in the future to fund our operations, to finance subscriber acquisition costs, to enhance or expand the range of Internet services we offer or to respond to competitive pressures or perceived opportunities. We cannot be sure that additional financing will be available on terms favorable to us, or at all. If adequate funds are not available or not available when required or on acceptable terms, we may be forced to cease our operations, and even if we are able to continue our operations, our business and financial results may suffer. WE MAY NOT BE ABLE TO SUCCESSFULLY MAKE ACQUISITIONS OF OR INVESTMENTS IN OTHER COMPANIES We have no experience in acquiring or making investments in companies, technologies or services. From time to time we have had discussions with companies regarding our acquiring, or investing in, their businesses, products or services, or customers. We have no present understanding or agreement relating to any acquisition or investment. If we buy a company, we could have difficulty in assimilating that company's personnel and operations. In addition, the key personnel of the acquired company may decide not to work for us. If we make other types of acquisitions, we could have difficulty in assimilating the acquired services, technologies or customers into our operations. These difficulties could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect our results of operations due to accounting requirements such as the amortization of goodwill. Furthermore, we may incur debt or issue equity securities to pay for any future acquisitions. The issuance of equity securities could be dilutive to our existing stockholders. WE COULD FACE ADDITIONAL REGULATORY REQUIREMENTS, TAX LIABILITIES AND OTHER RISKS IF WE DECIDE TO EXPAND INTERNATIONALLY We may decide to expand internationally, and believe that any international operations would be subject to most of the risks of our business generally. In addition, there are risks inherent in doing business in international markets, such as changes in regulatory requirements, tariffs and other trade barriers, fluctuations in currency exchange rates, and adverse tax consequences, and there are likely to be different consumer preferences and requirements in such markets. We cannot assure you that one or more of these factors would not harm any future international operations. FUTURE SALES OF OUR COMMON STOCK MAY NEGATIVELY AFFECT OUR STOCK PRICE We have a large number of shares of common stock outstanding and available for resale beginning at various points in time in the future. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market, or the perception that such sales could occur. These sales also might make it more difficult for us to sell equity securities in the future at a price that we think is appropriate, or at all. Please see "Shares Eligible for Future Sale." OUR STOCK PRICE HAS EXPERIENCED, AND IS LIKELY TO CONTINUE TO EXPERIENCE, EXTREME PRICE AND VOLUME FLUCTUATIONS The stock market has experienced extreme price and volume fluctuations. The market prices of the securities of Internet-related companies have been especially volatile. Until recently, there has been no public market for our common stock. We cannot predict the extent to which investor interest in Juno will lead to the development of an active trading market or how liquid that market might become. We may suffer significant declines in the market price of our common stock. In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of our management's attention and resources. WE MAY SPEND A SUBSTANTIAL PORTION OF THE NET PROCEEDS OF THIS OFFERING IN WAYS WITH WHICH YOU MAY NOT AGREE We intend to spend a significant portion of the net proceeds of this offering on our marketing activities. Our management will have broad discretion, however, over the allocation of the net proceeds from this offering as well as over the timing of our expenditures. Investors may not agree with the way our management decides to spend these proceeds. Please see "Use of Proceeds." WE HAVE ANTI-TAKEOVER PROVISIONS WHICH MAY MAKE IT DIFFICULT FOR A THIRD PARTY TO ACQUIRE US Provisions of our certificate of incorporation, our bylaws and Delaware law could make it more difficult for a third party to acquire us, even if doing so might be beneficial to our stockholders. Please see "Description of Capital Stock." INVESTORS IN THIS OFFERING WILL SUFFER IMMEDIATE AND SUBSTANTIAL DILUTION Investors purchasing shares in the offering will incur immediate and substantial dilution in net tangible book value per share. To the extent outstanding options to purchase common stock are exercised, there will be further dilution. Please see "Dilution."

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+RISK FACTORS You should carefully consider the following risk factors before you invest in the notes. THE ABSENCE OF AN EXISTING MARKET FOR THE NOTES MAY LIMIT YOUR ABILITY TO RESELL THE NOTES There is currently no public market for the notes and we cannot assure you that one will develop. Thus, you may not be able to resell your notes at all, or may be able to do so only at a substantial discount. The underwriters may assist in resales of the notes but they are not obligated to do so. We do not intend to apply for listing of the notes on any securities exchange or for the inclusion of the notes on any automated quotation system. Even if a secondary market does develop, it may not continue. PREPAYMENTS ON THE CONTRACTS MAY CAUSE AN EARLIER REPAYMENT OF THE NOTES THAN YOU EXPECT AND YOU MAY NOT BE ABLE TO FIND INVESTMENTS WITH THE SAME YIELD AS THE NOTES AT THE TIME OF THE REPAYMENT. A higher than anticipated level of prepayments may cause us to pay principal on the notes sooner than you expected. Similarly, upon the occurrence of an event of default, you may also receive principal of the notes sooner than you expected. See "DESCRIPTION OF THE NOTES AND INDENTURE--EVENTS OF DEFAULT" and "PREPAYMENT AND YIELD CONSIDERATION". You may not be able to reinvest those distributions of principal at yields equivalent to the yield on the notes; therefore, the ultimate return you receive on your investment in the notes may be less than the return you expected on the notes. The rate of early terminations of contracts due to prepayments, including defaults, is influenced by various factors including: - technological change; - changes in customer requirements; - the level of interest rates; - the level of casualty losses; and - the overall economic environment. We cannot assure you that prepayments on the contracts held by the trust will conform to any historical experience. We cannot predict the actual rate of prepayments which will be experienced on the contracts. THE PRICE AT WHICH YOU CAN RESELL YOUR NOTES MAY DECREASE IF THE RATINGS OF YOUR NOTES CHANGE [ ] are the rating agencies rating the notes. At any time, a rating may be lowered or withdrawn entirely by a rating agency rating the notes. In the event that the rating initially assigned to any note is subsequently lowered or withdrawn for any reason, you may not be able to resell your notes without a substantial discount. For more detailed information regarding the ratings assigned to any class of the notes, see "RATING OF THE NOTES." THE SUBORDINATION OF THE CLASS A-2 NOTES, CLASS A-3 NOTES, CLASS A-4 NOTES, CLASS B NOTES, THE CLASS C NOTES, THE CLASS D NOTES AND THE CLASS E NOTES IS A LIMITED FORM OF CREDIT ENHANCEMENT We will pay interest and principal on some classes of notes prior to paying interest and principal on other classes of notes. See "DESCRIPTION OF THE NOTES AND INDENTURE--ALLOCATIONS". The subordination of some classes of notes to others means that the subordinated classes of notes are more likely to suffer the consequences of delinquent payments and defaults on the contracts than the notes which receive payments prior to those subordinated classes.

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+RISK FACTORS Any investment in our common stock involves a high degree of risk. You should consider the risks described below carefully and all of the information contained in this prospectus before deciding whether to purchase our common stock. RISKS RELATED TO OUR FINANCIAL RESULTS WE RECOGNIZED OUR FIRST REVENUES IN THE THREE-MONTH PERIOD ENDED MARCH 31, 2000, AND AS A RESULT, YOU MAY HAVE DIFFICULTY EVALUATING OUR BUSINESS AND ASSESSING ITS FUTURE VIABILITY. Our limited historical financial performance may make it difficult for you to evaluate the success of our business to date and to assess its future viability. Our company was founded in March 1997. We received orders from our first customers in December 1999 and recorded our first revenues in the first quarter of 2000. An investor in our common stock must consider the risks and difficulties we may encounter as an early stage company in the new and rapidly evolving market for broadband wireless equipment. We may not achieve our goal of becoming a leading worldwide provider of broadband wireless equipment. In addition, because we have only recently begun commercial shipment of our products, we may have limited insight into trends that may emerge and affect our business. If we fail to respond to such trends and execute our business strategy, we may not be able to achieve and maintain profitability. IF WE CONTINUE TO INCUR SUBSTANTIAL LOSSES AND NEGATIVE OPERATING CASH FLOWS WE MAY NOT SUCCEED IN ACHIEVING OR MAINTAINING PROFITABILITY IN THE FUTURE AND THE MARKET PRICE OF OUR COMMON STOCK MAY DECLINE AS A RESULT. We may never achieve profitability. Our failure to achieve or maintain profitability could cause the market price of our common stock to decline. Since inception, we have incurred significant net losses, including net losses of $2.5 million in the period from inception through December 31, 1997, $17.2 million in 1998, $31.9 million in 1999 and $10.9 million for the three months ended March 31, 2000. As a result of ongoing operating losses, we had an accumulated deficit of $62.5 million as of March 31, 2000. We anticipate that our expenses will increase substantially in the foreseeable future and that we will continue to incur substantial losses for the foreseeable future. We also expect to experience negative operating cash flow for the foreseeable future as we fund our operating losses and capital expenditures. We will need to generate significant revenues to achieve and maintain profitability. DUE TO OUR LIMITED OPERATING HISTORY, THE FACT THAT WE COMPETE IN A NEW AND RAPIDLY GROWING MARKET, AND THE FACT THAT A SIGNIFICANT PERCENTAGE OF OUR EXPENSES ARE FIXED AND DO NOT VARY WITH REVENUES, OUR QUARTERLY OPERATING RESULTS AND STOCK PRICE MAY FLUCTUATE. We may not be able to forecast our quarterly shipments due to a variety of factors, including our limited operating history and the fact that our customers are not required to purchase specified numbers of Invisible Fiber units on a quarterly basis. Accordingly, it is difficult to predict the quarterly revenues that we will recognize. A significant percentage of our expenses, particularly salaries and rent, do not vary with our revenues. If we experience a shortfall in revenues in relation to our expenses, we may be unable to reduce our expenses quickly enough to avoid lower than anticipated quarterly operating results. In addition, our expenses have increased, and will continue to increase, with the anticipated growth in our business. We do not know whether our revenues will grow rapidly enough to absorb these costs. As a result, our quarterly operating results could fluctuate, and such fluctuation could cause the market price of our common stock to decline. We do not believe that period-to-period comparisons of our revenues and operating results are necessarily meaningful. You should not rely on the results of any one quarter as an indication of future performance. WE EXPECT TO RELY ON SALES OF OUR CURRENT INVISIBLE FIBER PRODUCTS FOR A SIGNIFICANT PORTION OF OUR REVENUES, AND IF THESE PRODUCTS FAIL TO ACHIEVE MARKET ACCEPTANCE WE MAY NEVER ACHIEVE PROFITABILITY. If we are unable to sell sufficient quantities of our products at acceptable prices, we may not achieve or maintain profitability. We expect to derive a significant portion of our revenues for the foreseeable future from sales of our 38 Gigahertz and the 28, 29 and 31 Gigahertz, or Local Multipoint Distribution Service frequencies, Invisible Fiber Internet and SONET products. The following factors, some of which are beyond our control, could affect demand for, or pricing or market acceptance of these products: - the adoption of broadband wireless solutions over competing technologies; - the growth and changing requirements of the market for broadband wireless equipment; - the successful development of our relationships with service providers; - the ability of service providers to obtain the financing, licensed radio frequency and roof rights needed to deploy their networks; - the performance, quality, price and total cost of ownership of our products; and - the performance, quality, price, total cost of ownership and availability of competing products. IF WE ARE NOT SUCCESSFUL IN DEVELOPING AND MARKETING NEW AND ENHANCED BROADBAND WIRELESS PRODUCTS THAT KEEP PACE WITH TECHNOLOGY AND OUR CUSTOMERS' NEEDS, OUR FUTURE SALES MAY SUFFER. We may not be successful in developing and marketing, on a timely and cost-effective basis, either enhancements to our products or new products that respond to technological advances and satisfy increasingly sophisticated customer needs. If we fail to introduce new products or to enhance existing products, we may not be able to retain our current customers or sell our products to new customers. In addition, if new industry standards emerge that we do not anticipate or adapt to, our products could be rendered obsolete. The market for our products is new and emerging, and is characterized by rapid technological advances, changing customer needs, evolving industry standards and a high degree of competition. We are seeking to develop new versions of our products to support additional frequency bands and higher transmission speeds and to develop enhancements to our existing products. Developing new products and product enhancements requires significant additional expenditures and research and development resources. WE CURRENTLY DEPEND ON THREE KEY CUSTOMERS FOR SUBSTANTIALLY ALL OF OUR SALES AND THE LOSS OF ONE OR MORE OF THEM, OR ANY FUTURE CUSTOMER ON WHOM WE MAY DEPEND FOR A SIGNIFICANT PORTION OF OUR SALES, COULD SIGNIFICANTLY REDUCE OUR REVENUES. We currently depend on Advanced Radio Telecom, CenturyTel and CAVU for substantially all of our sales. Moreover, because we focus our sales efforts on selected service providers, we anticipate our operating results will continue to depend on sales to a small number of key customers for the foreseeable future. The loss of one or more of our current customers, a reduction in sales to them or the failure to sell our products to additional service providers would significantly reduce our future revenues. LONG SALES CYCLES MAY CONSTRAIN REVENUE GROWTH. Long sales cycles may restrict our ability to generate revenue growth. We do not have enough historical experience selling our products to determine how our sales cycle will affect our revenues. In obtaining our first three customers we experienced sales cycles ranging from four to twelve months, and we expect that our sales cycles will continue to be long and unpredictable. Because of the cost and complexity of our products, most potential customers will need substantial time to understand our technology and the benefits offered by our products, including time for testing and evaluation. In addition, we believe a typical customer is likely to initially purchase a small number of units and then incrementally increase the size of the installation over time. A number of factors affect the length of time the customer needs before it selects us as a vendor or begins placing orders for shipment. These factors include: - the customer's ability to obtain the financing and licensed radio frequency needed to deploy its networks; - the type and size of the customer and the nature of its internal decision processes; - the length of the customer's product testing and evaluation period; - the time required by the customer to plan its network development; - the time required by the customer to deploy its network, which may be affected by the customer's ability to secure suitable roof rights; - the size, breadth and configuration of the customer's network; and - the customer's ability to obtain subscribers for its services. A FAILURE TO ESTABLISH AND EXPAND RESELLER DISTRIBUTION CHANNELS AND TO CONTINUE PROVIDING HIGH QUALITY CUSTOMER SUPPORT COULD RESTRICT GROWTH. Our inability to effectively establish and expand our indirect distribution channels could harm our ability to grow and increase revenue. Some prospective customers may prefer to work with vendors that can supply all of the customer's network needs, including not only broadband wireless solutions but also wireline solutions and related equipment for the customer premise and the carrier's central office. As our competitors forge relationships with large resellers that offer more comprehensive product and service offerings, we may need to do the same. If we are unable to develop relationships with significant resellers, or if these resellers are not successful in their sales efforts, sales of our products could decrease. We may need to increase our customer service and support staff to support new and existing customers and resellers. The design and installation of networking products can be complex and our customers, particularly our Internet service provider customers, may require a high level of sophisticated support and services. Hiring highly trained customer service and support personnel is very competitive in our industry due to the limited number of people available with the necessary technical skills and understanding of our products. If we are not successful in attracting and retaining such personnel it would be difficult for us to execute our business plan effectively. WE RELY ON THE SERVICES OF OUR EXECUTIVE OFFICERS AND KEY ENGINEERING AND SALES AND MARKETING PERSONNEL, NONE OF WHOM ARE BOUND BY EMPLOYMENT AGREEMENTS. THE LOSS OF ANY OF THESE PERSONS COULD RESULT IN DELAYS IN PRODUCT DEVELOPMENT, LOSS OF CUSTOMERS AND SALES AND DIVERSION OF MANAGEMENT RESOURCES, AND CAUSE OUR BUSINESS TO SUFFER. Our ability to implement our business strategy and our future success depends largely on the continued services of our executive officers and other key engineering, sales, marketing and support personnel who have critical industry or customer experience and relationships. None of our key personnel is bound by an employment agreement. We have no key man life insurance. The loss of the technical knowledge and management and industry expertise of any of these key personnel could result in delays in product development, loss of customers and sales and diversion of management resources, which could produce lower than anticipated operating results. DUE TO THE INCLUSION OF EXCESS INFORMATION ABOUT TRITON AND A HYPERLINK TO OUR WEB SITE IN THE PRESS RELEASE ANNOUNCING OUR FILING OF A REGISTRATION STATEMENT IN CONNECTION WITH THIS OFFERING, WE MAY HAVE LIABILITY FOR A POSSIBLE VIOLATION OF SECTION 5 OF THE SECURITIES ACT OF 1933. Our press release announcing the offering contained excess information about Triton and a hyperlink to our Web site, which, at the time, contained statements about Triton not included in the prospectus. Because of the excess information and the hyperlink, our press release may have constituted a prospectus that did not meet the requirements of the Securities Act, in which case the existence of the excess information or the hyperlink may have caused us to violate Section 5 of the Securities Act. We urge all persons to read and base their investment decision only on this preliminary prospectus dated July 12, 2000 and the final prospectus. If the excess information and the existence of the hyperlink caused a violation of Section 5 of the Securities Act, we believe that only purchasers in this offering that relied on the press release and accessed the Web site through the hyperlink and relied on the now deleted statements not included in the prospectus would have the right, for a period of one year from the date of their purchase of common stock, to bring an action for rescission or for damages resulting from their purchase of common stock. We cannot assure you, however, that if such a violation occurred this right would be limited to those purchasers. We do not believe that the inclusion of this excess information or the hyperlink caused a violation of Section 5, and if any such claim were asserted, we would contest the matter vigorously. Accordingly, we do not believe that our exposure, if any, resulting from the press release would be material to our results of operations or financial condition. RISKS RELATED TO MARKET ACCEPTANCE OF OUR PRODUCTS THE RATE OF MARKET ADOPTION OF OUR CONSECUTIVE BROADBAND WIRELESS TECHNOLOGY MAY BE LIMITED BY LACK OF MARKET AWARENESS AND OTHER FACTORS. Our consecutive point broadband wireless solutions compete with other high-speed solutions such as digital subscriber lines, coaxial cable, fiber optic cable, satellite and point-to-point and point-to-multipoint wireless technologies. Many of these alternative technologies can take advantage of existing installed infrastructure and have achieved significantly greater market acceptance and penetration than broadband wireless technologies, including our consecutive point broadband wireless technology. By comparison, since we are the first company to offer a consecutive point wireless solution, we must undertake substantial marketing efforts to make prospective customers aware of our products and to persuade their engineering organizations to accept a new technological approach. Moreover, current broadband wireless technology, including our consecutive point broadband wireless technology, has inherent technical limitations that may inhibit its widespread adoption in many areas, including reduced communication distance in bad weather and the need for line-of-sight installation. We expect broadband wireless technologies, including our consecutive point broadband wireless technology, to face increasing competitive pressures from both current and future alternative technologies. In light of these factors, many service providers may be reluctant to invest heavily in consecutive point broadband wireless solutions and, accordingly, the market for these solutions may fail to develop or may develop more slowly than we expect. Either outcome would limit our sales opportunities and make it difficult for us to achieve profitability. THE BROADBAND WIRELESS INDUSTRY IS INTENSELY COMPETITIVE, AND OUR FAILURE TO COMPETE EFFECTIVELY COULD HURT OUR SALES. The market for broadband wireless equipment is rapidly evolving, fragmented, highly competitive and subject to rapid technological change. A number of large telecommunications equipment suppliers, such as Digital Microwave Corporation, Harris Corporation and P-Com, Inc., as well as a number of smaller companies have developed or are developing products that compete with ours. Some of our competitors are substantially larger than we are, have longer operating histories and have greater financial, sales, marketing, distribution, technical, manufacturing and other resources. Some also have greater name recognition and a larger installed base of customers than we have. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our target markets. As a result, our competitors may be able to respond more quickly to evolving industry standards and changes in customer requirements, or to devote greater resources to the development, promotion and sale of their products than we can. In addition, current and potential competitors may make strategic acquisitions or establish cooperative relationships among themselves or with third parties to increase their ability to gain market share rapidly. We also expect that industry consolidation could increase competition. We expect to face increasing competitive pressures from both current and future competitors. Increased competition could result in reduced demand for our products, price reductions and reduced gross margins for our products. AS OUR CUSTOMERS ENTER NEW MARKETS, WE SOMETIMES HAVE TO ADAPT OUR PRODUCTS RAPIDLY TO THE LICENSED FREQUENCY BANDS AND REGULATORY REQUIREMENTS THAT EXIST IN THOSE MARKETS, AND WE MAY INCUR SIGNIFICANT COSTS MAKING THE NECESSARY MODIFICATIONS. Each of our products is designed for a specific range of frequency bands. Because different governments license different portions of available radio frequency for the broadband wireless market, and because service providers license specific frequency bands, we sometimes have to adapt our products rapidly to use different frequency bands. This design process can be difficult and time-consuming, and could therefore increase our costs and cause delays in the delivery of products to our customers. RISKS RELATED TO OUR PRODUCT MANUFACTURING IF WE ARE UNABLE TO MANUFACTURE SUFFICIENT QUANTITIES TO MEET EXISTING AND FUTURE CUSTOMER DEMAND, WE MAY NOT ACHIEVE OR MAINTAIN PROFITABILITY. We currently rely on third party manufacturers to produce some components used in our products and our own manufacturing capabilities for final assembly and testing of our products. Except for our agreement with Lockheed Martin described below, we do not have long-term contracts with any of our third party manufacturers. We have experienced and may in the future experience delays in shipments from our manufacturers, which could in turn delay product shipments to our customers. We may in the future experience other manufacturing problems, such as inferior quality and insufficient quantities of components or finished product. Such delays, quality problems and shortages could cause us to lose sales and customers, and thereby harm our business and operating results. We intend to introduce new products and product enhancements regularly, which will require us to achieve volume production rapidly by coordinating our efforts with those of our third party component manufacturers. We may need to find one or more new manufacturers that can manufacture the components used in our products in higher volumes and at lower costs. We may be unable to secure contract manufacturers that meet our needs. Additionally, qualifying new manufacturers and commencing volume production is expensive and time consuming. If we are required or choose to change manufacturers, we may lose sales and our customer relationships may suffer. THE CURRENT MANUFACTURER OF THE TRANSMITTER AND RECEIVER, OR TRANSCEIVER MODULE, USED IN OUR PRODUCTS IS NEARING CAPACITY. IF WE CANNOT BEGIN VOLUME MANUFACTURING OF TRANSCEIVER MODULES AT OUR NEW MANUFACTURING FACILITY IN THE SECOND HALF OF 2000, WE WILL NOT BE ABLE TO MEET DEMAND FOR OUR PRODUCTS FROM EXISTING AND FUTURE CUSTOMERS, AND WE MAY LOSE SALES AND GENERATE LOWER THAN ANTICIPATED REVENUES AS A RESULT. In response to our current capacity constraints, we plan to begin volume production of transceiver modules at our manufacturing facility in Orlando, Florida in the second half of 2000. We may experience problems and delays in connection with this and other manufacturing initiatives. If we cannot quickly achieve volume production of transceiver modules or if we experience related disruptions, capacity constraints or quality control problems, then product shipments to our customers could be delayed. Such delays would negatively impact our revenues, competitive position and reputation. BECAUSE WE DEPEND ON SINGLE SOURCE AND LIMITED SOURCE SUPPLIERS OF COMPONENTS OF OUR PRODUCTS INCLUDING TRANSCEIVER MODULES, SYNTHESIZERS AND HIGH-POWER AMPLIFIERS, WE ARE SUSCEPTIBLE TO SUPPLY SHORTAGES FOR THESE COMPONENTS THAT COULD ADVERSELY AFFECT OUR ABILITY TO MEET EXISTING AND FUTURE CUSTOMER DEMAND FOR OUR PRODUCTS AND CAUSE US TO MAKE FEWER SHIPMENTS AND GENERATE LOWER THAN ANTICIPATED REVENUES. If we encounter shortages or delays in obtaining components for our products in sufficient quantities when required, delivery of our products could be delayed, resulting in customer dissatisfaction and decreased revenues. In addition, our suppliers may enter into exclusive arrangements with our competitors, stop selling their products or components to us at commercially reasonable prices or refuse to sell their products or components to us at any price, which could harm our results of operations. We currently purchase several key components used in our products from single or limited sources and depend on supply from these sources to meet our needs. We acquire these key components through purchase orders and, other than our agreement with Lockheed Martin, have no long-term commitments regarding supply or price from these suppliers. We have entered into an agreement with Lockheed Martin to provide 3,200 transceiver modules by the end of the first half of 2001. Lockheed Martin will be our primary supplier of transceiver modules until we begin volume production at our facility in the second half of 2000. Verticom is the only supplier of 38 Gigahertz synthesizers and their ability to meet our demand has been inconsistent. In addition, Raytheon is the sole supplier of the high-power amplifier used in our transceiver modules, and Polese is the sole supplier of the housings used in our products. Additional single or limited source components may be incorporated in our products in the future. IF WE FAIL TO FORECAST DEMAND FOR OUR PRODUCTS ACCURATELY, WE COULD LOSE SALES AND INCUR INVENTORY LOSSES. We have long lead times for many of the components we use, which often requires that we order components based on our sales forecasts, rather than actual customer orders. However, because our sales history is limited and because our sales cycles have been long and varying, we may not be able to make accurate sales forecasts. If we forecast incorrectly and overestimate our component requirements, we may have excess inventory, which would increase our costs and subject us to increased risk of obsolescence. If we underestimate our component requirements, we may have inadequate inventory, which could interrupt our manufacturing, delay delivery of our products to our customers and cause us to lose sales. RISKS RELATED TO OUR PRODUCTS OUR PRODUCTS CONSIST OF SEVERAL HIGHLY TECHNICAL COMPONENTS, ANY OF WHICH COULD CONTAIN DEFECTS WHICH INTERFERE WITH THE PERFORMANCE OF OUR PRODUCTS. Despite testing by us and our customers, errors may be found in our products after commencement of commercial shipments. We and our customers have from time to time discovered errors in our products. In the future, there may be additional errors and defects in our products. If errors are discovered, we may not be able to successfully correct them in a timely manner or at all. Errors and failures in our products could result in network outages for our customers, a loss of or delay in market acceptance and damage to our reputation and our ability to convince service providers of the benefits of our products. In addition, we may need to make significant expenditures of capital resources in order to eliminate errors and failures. Moreover, because our products are used in critical communications networks, we may receive significant liability claims if any products do not work properly. Our insurance policies and the limitations on liability in our agreements with customers may not adequately limit our exposure to such claims. IF INTERFERENCE FROM OTHER RADIOS OPERATING IN A SERVICE AREA OR ADVERSE WEATHER CONDITIONS CAUSE OUR PRODUCTS TO MALFUNCTION, OUR REPUTATION COULD BE HARMED AND OUR SALES MAY DECREASE. Many of our customers will provide service in large, densely populated metropolitan areas where wireless traffic is heavy. If multiple wireless systems are operating in these service areas concurrently with our products, the radio frequency on which our products operate could become saturated, resulting in signal interference. If that occurred, the quality or availability of our customers' transmissions could decrease or our products could fail, causing service delays and interruptions. Interference caused by severe weather conditions could lead to similar failures. The ability of our products to provide our customers with high quality and reliable transmissions at all times and under a variety of adverse conditions is key to our success. If our products fail we may suffer: - the loss of or delay in market acceptance and sales of our products; - cancellation of orders; - diversion of development resources; - injury to our reputation; and - increased maintenance and warranty costs. LINE OF SITE RESTRICTIONS INHERENT IN OUR PRODUCTS COULD LIMIT DEPLOYMENT OPTIONS AND HAVE A NEGATIVE IMPACT ON OUR REVENUES. Our products require a direct line of sight, potentially limiting the ability of service providers to deploy them in a cost-effective manner. Because of line of sight limitations, service providers will often install broadband wireless equipment on the rooftops of buildings and on other tall structures. Service providers must generally secure roof rights from the owners of each building or other structure on which the equipment is to be installed. The inability to obtain roof rights easily and cost-effectively may cause potential customers to choose not to install broadband wireless equipment, resulting in fewer sales of our products and lower than expected revenues. RISKS RELATED TO THE EXPANSION OF OUR BUSINESS SINCE OUR INCEPTION IN MAY 1997, WE HAVE EXPERIENCED SIGNIFICANT AND RAPID GROWTH THAT HAS PLACED, AND CONTINUES TO PLACE, A SIGNIFICANT STRAIN ON OUR MANAGEMENT, OPERATING INFRASTRUCTURE AND RESOURCES. OUR FAILURE TO MANAGE THIS GROWTH AND ANY FUTURE GROWTH COULD PREVENT US FROM ACHIEVING AND MAINTAINING PROFITABILITY. Our failure to manage the expansion of our business and operations could slow our development and prevent us from achieving or maintaining profitability. Our success will depend on our ability to manage our growth effectively, and in particular, our success in: - meeting the increasing product volume requirements of existing and future customers; and - enhancing our operational and financial control, human resources and information systems. FUTURE EXPANSION OF OUR INTERNATIONAL OPERATIONS WILL REQUIRE SIGNIFICANT MANAGEMENT ATTENTION AND FINANCIAL RESOURCES, AND OUR EFFORTS TO EXPAND INTERNATIONALLY MAY NOT SUCCEED. We plan to increase our international sales activities significantly, but we have limited experience in developing foreign language materials to support our products and little direct experience marketing and distributing our products internationally. We currently conduct limited, targeted sales activities in Canada, Australia and Japan. To successfully expand international sales, we must expand our international operations, recruit additional international sales and support personnel, and expand our international distribution channels. This expansion will require significant management attention and financial resources, and may not be successful. Our success in international markets may also depend on our ability to modify our existing products and develop new products supporting frequency bands that are different from those used by service providers in the United States. ANY DIFFICULTIES WE ENCOUNTER IN INTEGRATING OUR RECENT ACQUISITION OF IBM'S BROADBAND MODEM PRODUCT LINE, AND ANY FUTURE ACQUISITIONS, COULD DISRUPT OUR ONGOING BUSINESS, DISTRACT OUR MANAGEMENT AND EMPLOYEES, INCREASE OUR EXPENSES AND ADVERSELY AFFECT OUR RESULTS OF OPERATIONS. We may encounter difficulty integrating the personnel we hired, and operations, technology and software we acquired, from IBM. Any difficulties could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect our results of operations. In the future, we may acquire, or invest in, complementary businesses, products, or technologies. Acquisitions involve numerous risks, including: - difficulties in integrating operations, technologies, products and personnel; - diversion of financial and management resources from existing operations; - risks of entering new markets; - potential loss of key employees; and - inability to generate sufficient revenues to offset acquisition or investment costs. If we finance an acquisition by issuing additional equity securities, our stockholders could experience dilution. In addition, acquisitions may involve investment-related or other charges and amortization of acquired technology, goodwill and other intangible assets. COMPETITION FOR QUALIFIED ENGINEERING PERSONNEL WITH RADIO FREQUENCY EXPERTISE, AS WELL AS SALES, MARKETING AND CUSTOMER SUPPORT PERSONNEL WITH SIGNIFICANT TELECOMMUNICATIONS EQUIPMENT INDUSTRY EXPERIENCE, IS INTENSE, AND IF WE ARE NOT SUCCESSFUL IN ATTRACTING AND RETAINING PERSONNEL, OUR ABILITY TO GROW OUR BUSINESS MAY BE HARMED. Our future performance depends on our ability to attract and retain highly qualified sales, engineering personnel with radio frequency expertise, as well as sales, marketing and customer support personnel with significant telecommunications equipment industry experience. Competition for qualified personnel in the telecommunications equipment industry is intense, and we may not be successful in attracting and retaining such personnel. We are actively searching for research and development engineers, sales and marketing and customer service and support personnel, all of whom are in short supply. If we do not succeed in retaining our personnel or in attracting new employees, our business could suffer. Competitors and others have in the past, and may in the future, attempt to recruit our employees. We have in the past and may in the future attempt to recruit employees from our competitors. Companies whose employees accept positions with competitors frequently claim that the competitors have engaged in unfair hiring practices. We have received such complaints in the past, and may receive such complaints in the future as we seek to hire qualified personnel. These complaints may result in material litigation and related disruption to our operations. OUR OFFICERS, DIRECTORS AND PERSONS OR ENTITIES AFFILIATED WITH OUR DIRECTORS WILL RETAIN SIGNIFICANT CONTROL OVER US AFTER THE OFFERING, WHICH MAY LEAD TO CONFLICTS WITH OTHER STOCKHOLDERS OVER CORPORATE GOVERNANCE ISSUES. We anticipate that our officers, directors and individuals or entities affiliated with our directors will beneficially own approximately 36.7% of our outstanding common stock as a group after this offering closes. Acting together, these stockholders would be able to significantly influence all matters that our stockholders vote upon, including the election of directors and the approval of significant corporate transactions. This concentration of ownership may also delay, deter or prevent a change in our control and may make some transactions more difficult or impossible to complete without the support of these stockholders. FOLLOWING THIS OFFERING APPROXIMATELY 33,830,932 SHARES OF OUR COMMON STOCK WILL BE OUTSTANDING AND FUTURE SALES OF THESE SHARES OF COMMON STOCK BY OUR EXISTING STOCKHOLDERS COULD CAUSE OUR STOCK PRICE TO FALL. If our stockholders sell substantial amounts of common stock in the public market, the market price of our common stock could fall. The perception among investors that these sales will occur could produce the same effect. After this offering, we will have approximately 33,830,932 shares of common stock outstanding. The shares we are selling in this offering will be freely tradable in the public market. If we take into account the lock-up agreements executed by our existing stockholders, the remaining shares of common stock outstanding after this offering will be available for sale in the public market as follows: <TABLE> <CAPTION> PERCENT OF TOTAL SHARES NUMBER OF SHARES OUTSTANDING DATE OF AVAILABILITY FOR SALE ---------------- ------------ -------------------------------- <S> <C> <C> 1,954,834....................... 6.9% _____________, 2000 (date of this prospectus) to _____________, 2001 (180 days after the date of this prospectus) 23,599,666...................... 83.3% _____________, 2001 (180 days after the date of this prospectus), in some cases under Rule 144 2,776,432....................... 9.8% at various times after _____________, 2001 </TABLE> Our underwriters could waive the selling restrictions imposed by the lock-up agreements at any time, which could accelerate the resale of outstanding shares of common stock. In addition, some of our securityholders have rights to require us to register their shares for resale in the public market.

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+RISK FACTORS Investing in our common stock is very risky. You should carefully consider the following risk factors and all other information contained in this prospectus before purchasing our common stock. If any of the following risks actually occurs, our business, financial condition or results of operations could be materially harmed. In such event, the trading price of our common stock could decline, and you may lose all or part of your investment. References to "strategic partners" or "strategic relationships" are not intended to necessarily imply any equity ownership in us by such entities. RISKS RELATED TO OUR BUSINESS AND OUR INDUSTRY THE TECHNOLOGY USED IN THE SEMICONDUCTOR INDUSTRY IS RAPIDLY CHANGING AND IF WE ARE UNABLE TO DEVELOP NEW TECHNOLOGIES AND ADAPT OUR EXISTING INTELLECTUAL PROPERTY TO NEW PROCESSES, WE WILL BE UNABLE TO ATTRACT OR RETAIN CUSTOMERS. The semiconductor industry has been characterized by an increasingly rapid rate of development of new technologies and manufacturing processes. Our future success depends on our ability to develop new technologies, to adapt our existing intellectual property to satisfy the requirements of new processes and to introduce new products to the marketplace in a timely manner. As new technologies or manufacturing processes are announced, customers may defer licensing our intellectual property until those new technologies become available or our intellectual property have been adopted for that manufacturing process. If our development efforts are not successful or are significantly delayed, we may be unable to attract or retain customers. Our ability to develop technical innovations involves several risks, including: - our ability to anticipate and respond in a timely manner to changes in the requirements of semiconductor companies; - the emergence of new semiconductor manufacturing processes and our ability to enter into strategic relationships with third-party semiconductor foundries to develop and test technologies for these new processes and provide customer referrals; - the significant research and development investment that we may be required to make before market acceptance, if any, of a particular technology; - the possibility that the industry may not accept a new technology after we have invested a significant amount of resources to develop it; and - new technologies introduced by our competitors. If we are unable to adequately address these risks, our intellectual property will become obsolete and we will be unable to sell our products. Research and development requires a significant expense and resource commitment. Since we have a limited operating history and have only generated limited profits, we are unable to predict our future resources. As a result, we may not have the financial and other resources necessary to develop the technologies demanded in the future. In addition, since new technologies are being rapidly introduced, the industry may not accept the enhancements or new generations of the products that we develop and these new products may not generate revenues in excess of the costs of development. OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY AND ANY FAILURE TO MEET FINANCIAL EXPECTATIONS FOR ANY FISCAL QUARTER MAY DISAPPOINT SECURITIES ANALYSTS AND INVESTORS AND COULD CAUSE OUR STOCK PRICE TO DECLINE. Our quarterly operating results are likely to fluctuate in the future due to a variety of factors, many of which are outside of our control. Because our expenses are largely independent of our revenues in any particular period, we are unable to accurately forecast our operating results. As a result, if our revenues are below expectations in any quarter, our inability to adjust spending in a timely manner to compensate for the revenue shortfall may magnify the negative effect of the revenue shortfall. Factors that could cause our revenues and operating results to vary from quarter to quarter include: - large orders unevenly spaced over time; - establishment or loss of strategic relationships with third-party semiconductor foundries; - timing of new technologies and technology enhancements by us and our competitors; - shifts in demand for products that incorporate our intellectual property; - the impact of competition on license revenues or royalty rates; - the cyclical nature of the semiconductor industry; and - changes in development schedules, research and development expenditure levels and product support by us and semiconductor companies. As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and you should not rely on these comparisons as indications of future performance. These factors may cause our operating results to be below market analysts' expectations in some future quarters, which could cause the market price of our stock to decline. IF WE ARE UNABLE TO MAINTAIN EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WITH THIRD-PARTY SEMICONDUCTOR MANUFACTURERS, OR FOUNDRIES, WE WILL BE UNABLE TO VERIFY OUR TECHNOLOGIES ON THEIR PROCESSES AND LICENSE OUR INTELLECTUAL PROPERTY TO THEIR CUSTOMERS. Our ability to verify our technologies for new manufacturing processes depends on entering into development agreements with third-party foundries to provide us with access to these processes. In addition, we rely on third-party foundries to manufacture our silicon test chips and to provide referrals to their customer base. We currently have agreements with Taiwan Semiconductor Manufacturing Company, or TSMC, United Microelectronics Corporation, or UMC, and Chartered Semiconductor Manufacturing, or Chartered. If we are unable to maintain our existing relationships with these foundries or enter into new agreements with other foundries, we will be unable to verify our technologies for their manufacturing processes. We would then be unable to license our intellectual property to fabless semiconductor companies that use these foundries to manufacture their silicon chips, which is a significant source of our revenues. IF SEMICONDUCTOR COMPANIES DO NOT ADOPT OUR INTELLECTUAL PROPERTY AND DEMAND FOR THEIR PRODUCTS DOES NOT CONTINUE TO INCREASE, OUR REVENUES WILL DECLINE. Our continued success depends on the adoption and continued use of our intellectual property by semiconductor companies and an increasing demand for products requiring complex semiconductors and embedded memories, such as cellular and digital phones, pagers, digital cameras, DVD players, switches and modems. The markets for third-party semiconductor intellectual property and embedded memories have only recently begun to emerge. Our ability to achieve sustained revenue growth and profitability in the future will depend on the continued development of these markets and, to a large extent, on the demand for complex semiconductors. However, the semiconductor industry is highly cyclical and has fluctuated between significant economic downturns characterized by diminished demand, accelerated erosion of average selling prices and production overcapacity, as well as periods of increased demand and production capacity constraints. These types of fluctuations in the semiconductor industry may cause us to experience substantial period-to-period fluctuations in our operating results. Because of the cyclical nature of the semiconductor industry and the recent emergence of the third-party semiconductor intellectual property and embedded memory markets, these markets may not continue to develop or grow at a rate sufficient to support our business. A downturn or slower than expected growth in the semiconductor industry, a reduced number of design starts, tightening of customers' operating budgets or continued consolidation among our customers may seriously harm our revenues and profitability. IF WE ARE UNABLE TO CONTINUE TO ESTABLISH RELATIONSHIPS WITH SEMICONDUCTOR COMPANIES TO LICENSE OUR INTELLECTUAL PROPERTY, OUR BUSINESS WILL BE HARMED. We face numerous challenges in entering into license agreements with semiconductor companies on terms beneficial to our business, including: - the lengthy and expensive process of building a relationship with a potential licensee; - competition with the internal design teams of semiconductor companies; and - the need to persuade semiconductor companies to rely on us for critical technology. These factors may make it difficult for us to maintain our current relationships or establish new relationships with additional licensees. If we are unable to maintain and establish these relationships, we will be unable to generate license fees and our revenues will decrease. We do not obligate any of our licensees to license new or future generations of our intellectual property. WE HAVE A HISTORY OF LOSSES AND MAY NOT BE ABLE TO ACHIEVE SUSTAINED PROFITABILITY IN THE FUTURE. We have incurred significant losses in the past. At March 31, 2000, our accumulated deficit was $13.7 million. Because we have experienced a history of losses, we cannot predict whether we will be profitable in the future. Further, you should not rely on the historical growth of our revenues as any indication of our future operating results or prospects. IF WE ARE UNSUCCESSFUL IN INCREASING OUR ROYALTY-BASED REVENUES, OUR REVENUES AND PROFITABILITY MAY NOT BE AS LARGE AS WE ANTICIPATE. We have historically generated revenues almost entirely from license fees. In addition, we have agreements with certain third-party semiconductor foundries to pay us royalties on their sales of silicon chips they manufacture for our fabless customers. Beginning with our Custom-Touch 1T-SRAM and STAR mega-bit technologies that are currently in development, in addition to collecting royalties from third-party semiconductor foundries, we intend to increase our royalty base by collecting royalties directly from our integrated device manufacturer and fabless customers. We have not yet obtained agreements with any integrated device manufacturer or fabless customers that include these royalty payments and may be unable to do so. Even if we are successful obtaining these agreements, they may not have the anticipated benefits. Through March 31, 2000, we have received approximately $9,000 of royalty revenues. The amount of royalties we receive in the future may not be significant. In addition, many factors beyond our control, such as fluctuating sales volumes of products that incorporate our intellectual property, commercial acceptance of these products, accuracy of revenue reports and difficulties in the royalty collection process, limit our ability to forecast our royalty revenues. WE RELY ON A SMALL NUMBER OF CUSTOMERS FOR A SUBSTANTIAL PORTION OF OUR REVENUES. We have been dependent on a relatively small number of customers for a substantial portion of our annual revenues in each fiscal year, although the customers comprising this group have changed from time to time. In fiscal 1998, MMC Networks, National Semiconductor, PMC-Sierra, Silicon Dynamics and TeraLogic each generated more than 10% of our revenues for a total of 62% of our revenues. In fiscal 1999, ATI Technologies, MMC Networks, National Semiconductor and Toshiba each generated between 10% and 18% of our revenues for a total of 56% of our revenues. In the first half of fiscal 2000, IBM generated 10% of our revenues. We expect a small number of companies in the aggregate to represent between 20% to 40% of our revenues for the foreseeable future. The license agreements we enter into with our customers do not obligate them to license future generations of our intellectual property and, as a result, we cannot predict the length of our relationship with any significant customer. As a result of this customer concentration, we could experience a dramatic reduction in our revenues if we lose one or more of our major customers and are unable to replace them. There are a relatively limited number of fabless semiconductor companies and integrated device manufacturers to which we can license our intellectual property. As a result of this limited universe of potential customers, our future sales depend on these manufacturers continuing to rely on third-party semiconductor intellectual property and adopting our intellectual property for future product generations. THE MARKET FOR EMBEDDED MEMORY IS HIGHLY COMPETITIVE, AND WE MAY LOSE MARKET SHARE TO LARGER COMPETITORS WITH GREATER RESOURCES AND TO COMPANIES THAT DEVELOP THEIR OWN MEMORY TECHNOLOGIES USING INTERNAL DESIGN TEAMS. We face competition from both existing suppliers of embedded memories such as Artisan Components and Avant!, as well as new suppliers that may enter the market. We also compete with the internal design teams of large, integrated device manufacturers. Many of these internal design teams have substantial programming and design resources and are part of larger organizations with substantial financial and marketing resources. These internal teams may develop technologies that compete directly with our technologies or may actively seek to license their own technologies to third parties. We believe that our principal competitive advantages are the depth of our engineering expertise, our ability to offer manufacturing-tested products, the customizability of our products, the breadth of our product offering and our ability to offer memories for prevailing design technologies. However, many of our existing competitors have longer operating histories, greater brand recognition and larger customer bases, as well as greater financial and marketing resources, than we do. This may allow them to respond more quickly than we can to new or emerging technologies and changes in customer requirements. It may also allow them to devote greater resources than we can to the development and promotion of their products. WE MAY BE UNABLE TO ATTRACT AND RETAIN KEY PERSONNEL WHO ARE CRITICAL TO THE SUCCESS OF OUR BUSINESS. We believe that one of our significant competitive advantages is the size and quality of our engineering team. Our future success also depends on our ability to attract and retain engineers and other highly skilled personnel and senior managers. In addition, part of our strategy also involves expanding our domestic sales force and hiring sales representatives in Europe. If we are unable to increase our sales force with qualified employees, we will be unable to expand our business. Our employees are "at will" and may leave our employment at any time. Hiring qualified technical, sales and management personnel is difficult due to the limited number of qualified professionals and the intense competition in our industry for these types of employees. We have in the past experienced difficulty in recruiting and retaining qualified technical and sales personnel and believe that our employees are recruited aggressively by our competitors and start-up companies. Under certain circumstances, start-up companies can offer more attractive stock option packages than we offer. As a result, we may experience significant employee turnover. Failure to attract and retain personnel, particularly sales and technical personnel, would make it difficult for us to develop and market our technologies. In addition, our business and operations are substantially dependent on the performance of our key personnel, including Adam A. Kablanian, our President and Chief Executive Officer, and Alexander Shubat, our Vice President of Engineering and Chief Technology Officer. We do not have formal employment agreements with Mr. Kablanian or Mr. Shubat and do not maintain "key man" life insurance policies on their lives. If Mr. Kablanian or Mr. Shubat were to leave or become unable to perform services for our company, our business would be severely harmed. WE MAY BE UNABLE TO DELIVER OUR CUSTOMIZED MEMORY PRODUCTS IN THE TIME-FRAME DEMANDED BY OUR CUSTOMERS, WHICH COULD DAMAGE OUR REPUTATION AND FUTURE SALES. A significant portion of our contracts require us to provide customized products within a set delivery timetable. We have experienced delays in the progress of certain projects in the past, and we may experience such delays in the future. Any failure to meet significant customer milestones could damage our reputation in our industry and harm our ability to attract new customers. IF WE ARE UNABLE TO EFFECTIVELY MANAGE OUR GROWTH, OUR BUSINESS MAY BE HARMED. Our future success depends on our ability to successfully manage our growth. Our ability to manage our business successfully in a rapidly evolving market requires an effective planning and management process. Our customers rely heavily on our technological expertise in designing and testing our products. Relationships with new customers may require significant engineering resources. As a result, any increase in the demand for our products will increase the strain on our personnel, particularly our engineers. From January 1999 to June 2000, we grew from 38 to 126 full-time employees. This growth has placed, and is expected to continue to place, significant strain on our managerial and financial resources as well as our limited financial and management controls, reporting systems and procedures. Although some new controls, systems and procedures have been implemented, our future growth, if any, will depend on our ability to continue to implement and improve operational, financial and management information and control systems on a timely basis, together with maintaining effective cost controls. Since our growth has occurred over such a limited time period, we do not have sufficient experience managing the current size of our business to be able to fully assess our ability to continue to manage its growth in the future. Our inability to manage any future growth effectively would be harmful to our revenues and profitability. ANY ACQUISITIONS WE MAKE COULD DISRUPT OUR BUSINESS AND HARM OUR FINANCIAL CONDITION. We may attempt to acquire businesses or technologies that we believe are a strategic fit with our business. To date, we have acquired a portion of the assets owned by Mentor Graphics for total consideration of 150,000 shares of Series C preferred stock. We currently have no commitments or agreements for any material acquisition and no material acquisition is currently being pursued. Although we have not experienced significant operational difficulties with our acquisition of assets from Mentor Graphics, we believe that future acquisitions may result in unforeseen operating difficulties and expenditures and may absorb significant management attention that would otherwise be available for ongoing development of our business. Since we will not be able to accurately predict these difficulties and expenditures, it is possible that these costs may outweigh the value we realize from a future acquisition. Future acquisitions could result in issuances of equity securities that would reduce our stockholders' ownership interest, the incurrence of debt, contingent liabilities or amortization of expenses related to goodwill or other intangible assets and the incurrence of large, immediate write-offs. IF WE ARE NOT ABLE TO PROTECT OUR INTELLECTUAL PROPERTY ADEQUATELY, WE WILL HAVE LESS PROPRIETARY TECHNOLOGY TO LICENSE, WHICH WILL REDUCE OUR REVENUES AND PROFITS. Our patents, copyrights, trademarks, trade secrets and similar intellectual property are critical to our success. We rely on a combination of patent, trademark, copyright, mask work and trade secret laws to protect our proprietary rights. At July 27, 2000 we had four U.S. patents issued, eight pending U.S. patent applications and one draft application. In addition, we had two pending U.S. trademark applications. We cannot be sure that the U.S. Patent and Trademark Office will issue patents or trademarks for any of our pending applications. Further, any patents or trademark rights that we hold or may hold in the future may be challenged, invalidated or circumvented or may not be of sufficient scope or strength to provide meaningful protection or any commercial advantage to us. In addition, the laws of foreign countries may not adequately protect our intellectual property as well as the laws of the United States. We use licensing agreements and employee and third-party nondisclosure and assignment agreements to limit access to and distribution of our proprietary information and to obtain ownership of technology prepared on a work-for-hire basis. Even though we have taken all customary industry precautions, we cannot be sure that we have taken adequate steps to protect our intellectual property rights and deter misappropriation of these rights or that we will be able to detect unauthorized uses and take immediate or effective steps to enforce our rights. Since we also rely on unpatented trade secrets to protect some of our proprietary technology, we cannot be certain that others will not independently develop or otherwise acquire the same or substantially equivalent technologies or otherwise gain access to our proprietary technology or disclose that technology. We also cannot be sure that we can ultimately protect our rights to our unpatented proprietary technology. In addition, third parties might obtain patent rights to such unpatented trade secrets, which they could use to assert infringement claims against us. THIRD PARTIES MAY CLAIM WE ARE INFRINGING OR ASSISTING OTHERS TO INFRINGE THEIR INTELLECTUAL PROPERTY RIGHTS, AND WE COULD SUFFER SIGNIFICANT LITIGATION OR LICENSING EXPENSES OR BE PREVENTED FROM LICENSING OUR TECHNOLOGY. While we do not believe that any of our technology infringes the valid intellectual property rights of third parties, we may be unaware of intellectual property rights of others that may cover some of our technology. As a result, third parties may claim we or our customers are infringing their intellectual property rights. Our license agreements typically require us to indemnify our customers for infringement actions related to our technology. Any litigation regarding patents or other intellectual property could be costly and time-consuming, and divert our management and key personnel from our business operations. The complexity of the technology involved makes any outcome uncertain. If we do not prevail in any infringement action, we may be required to pay significant damages and may be prevented from developing some of our technology or from licensing some of our intellectual property for certain manufacturing processes unless we enter into a royalty or license agreement. In addition, if challenging a claim is not feasible, we might be required to enter into royalty or license agreements in order to settle a claim and continue to license or develop our intellectual property. These royalty or license agreements may result in significant expenditures. In addition, we may not be able to obtain such agreements on terms acceptable to us or at all, and thus, may be prevented from licensing or developing our technology. PROBLEMS ASSOCIATED WITH INTERNATIONAL BUSINESS OPERATIONS COULD AFFECT OUR ABILITY TO LICENSE OUR INTELLECTUAL PROPERTY. Sales to customers located outside the United States accounted for 48% of our revenues in fiscal 1998, 44% of our revenues in fiscal 1999 and 54% of our revenues in the six months ended March 31, 2000. We anticipate that sales to customers located outside the United States will increase and will continue to represent a significant portion of our total revenues in future periods. In addition, most of our customers that do not own their own fabrication plants rely on third-party foundries that may be outside of the United States. Accordingly, our operations and revenues are subject to a number of risks associated with foreign commerce, including the following: - managing foreign distributors; - staffing and managing foreign branch offices; - political and economic instability; - foreign currency exchange fluctuations; - changes in tax laws and tariffs; - timing and availability of export licenses; - inadequate protection of intellectual property rights in some countries; and - obtaining governmental approvals for certain technologies. If these risks actually materialize, our sales to international customers, as well as those domestic customers that use foreign fabrication plants, may decrease. CHANGES TO ACCOUNTING STANDARDS AND RULES COULD EITHER DELAY OUR RECOGNITION OF REVENUES OR REDUCE THE AMOUNT OF REVENUES THAT WE MAY RECOGNIZE AT A SPECIFIC TIME, AND THUS DEFER OR REDUCE OUR PROFITABILITY. THESE EFFECTS ON OUR REPORTED RESULTS COULD CAUSE OUR STOCK PRICE TO BE LOWER THAN IT OTHERWISE MIGHT HAVE BEEN. We adopted the American Institute of Certified Public Accountants' Statement of Position, or SOP, 97-2, "Software Revenue Recognition," and SOP 98-4, "Deferral of the Effective Date of a Provision of SOP 97-2, Software Revenue Recognition," as of October 1, 1998. In December 1998, the American Institute of Certified Public Accountants issued SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions." SOP 98-9 amends SOP 98-4 to extend the deferral of the application of certain passages of SOP 97-2 with respect to the fair value of elements in multiple-element arrangements. We implemented these provisions as of October 1, 1999. Although the adoption of SOP 97-2, SOP 98-4 and SOP 98-9 has not had, and we do not expect these adoptions to have, a material impact on our consolidated financial statements or results of operations, the American Institute of Certified Public Accountants has not issued full implementation guidelines for SOP 97-2, SOP 98-4 and SOP 98-9. In December 1999, the Securities and Exchange Commission issued SEC Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" which summarizes certain of the SEC's views in applying generally accepted accounting principles to revenue recognition in financial statements. Additional accounting guidance or pronouncements in the future could affect the timing of our revenue recognition in the future. RISKS RELATED TO THE OFFERING OUR PRINCIPAL STOCKHOLDERS HAVE SIGNIFICANT VOTING POWER AND MAY TAKE ACTIONS THAT MAY NOT BE IN THE BEST INTERESTS OF OUR OTHER STOCKHOLDERS. After this offering, our officers, directors and principal stockholders will together control approximately 60.0% of our outstanding common stock. As a result, these stockholders, if they act together, will be able to control our management and affairs and all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying or preventing a change in control and may affect the market price of our common stock. This concentration of ownership may not be in the best interest of our other stockholders. OUR RESTATED CERTIFICATE OF INCORPORATION AND BYLAWS WILL CONTAIN, AND DELAWARE LAW CONTAINS, PROVISIONS THAT COULD DISCOURAGE A TAKEOVER AND MAY NEGATIVELY AFFECT THE MARKET PRICE OF OUR COMMON STOCK. Our restated Certificate of Incorporation and bylaws will contain, and Delaware law contains, provisions that might enable our management to resist a takeover. These provisions might discourage, delay or prevent a change in the control of our company or a change in our management. In addition, these provisions could limit the price that investors would be willing to pay in the future for shares of our common stock. Some of these provisions which will be contained in our restated Certificate of Incorporation or bylaws: - divide our board of directors into three classes with each class subject to election every three years; - authorize the issuance of preferred stock that can be created and issued by our board of directors without prior stockholder approval, commonly referred to as "blank check" preferred stock, with rights senior to those of common stock; - prohibit stockholder action by written consent; and - establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by stockholders at a meeting. See "Description of Capital Stock" for a more detailed description of these provisions. A SALE OF A SUBSTANTIAL NUMBER OF SHARES OF OUR COMMON STOCK MAY CAUSE THE PRICE OF OUR COMMON STOCK TO DECLINE. If our stockholders sell substantial amounts of our common stock, including shares issued upon the exercise of outstanding options, in the public market following this offering, the market price of our common stock could fall. Such sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. Upon the closing of this offering and our simultaneous private placement of 403,226 shares to Crosslink Capital, Inc., or its affiliates, we will have outstanding 18,837,627 shares of common stock, based upon shares outstanding on March 31, 2000, as adjusted for the 1-for-2 reverse stock split, and assuming no exercise of outstanding options after March 31, 2000. Of these shares, the 3,750,000 shares sold in this offering will be freely tradable. Of the remaining shares of common stock outstanding immediately after this offering, approximately 13,500,000 shares will be available for sale in the public market 180 days after the date of this prospectus when the lock-up agreements between the underwriters and the stockholders expire. However, some of those sales will be subject to the volume restrictions imposed by Rule 144 under the federal securities laws on our affiliates. On occasion, underwriters have removed lock-up restrictions early and it is possible that Lehman Brothers Inc. may remove some or all of these restrictions earlier than 180 days after the closing of this offering. The remaining outstanding shares will become tradable upon expiration of various holding periods under Rule 144 (subject in some cases to the volume restrictions of that rule) or earlier and without restrictions if they are registered under the federal securities laws. After this offering, the holders of an aggregate of 7,196,276 shares of our common stock as well as the purchasers in the simultaneous private placement will have certain registration rights, including the right to require us to register the sale of their shares and the right to include their shares in public offerings we undertake in the future. See "Description of Capital Stock -- Registration Rights." WE MAY BE UNABLE TO RAISE CAPITAL IN THE FUTURE WHEN NEEDED WHICH COULD PREVENT US FROM GROWING. We believe that the net proceeds from this offering, together with cash generated by our operations, will be sufficient to meet our operating and capital requirements for at least the next 18 months. Aside from this offering, our primary sources of capital are our cash reserves and cash generated by operations. If our operations do not generate sufficient capital or if we have unexpected expenditures, we may need to raise additional funds through public or private financing or other arrangements. We cannot be certain that any such financing will be available on acceptable terms, or at all, and our failure to raise capital when needed could seriously harm our business. In addition, additional equity financing may dilute our stockholders' interest, and debt financing, if available, may involve restrictive covenants and could result in a substantial portion of our operating cash flow being dedicated to the payment of principal and interest on debt. If adequate funds are not available, we may need to curtail our operations significantly. OUR COMMON STOCK PRICE HAS NOT BEEN PUBLICLY TRADED, AND WE EXPECT THE PRICE OF OUR COMMON STOCK WILL FLUCTUATE SUBSTANTIALLY. Our common stock has not been publicly traded, and an active trading market may not develop or be sustained after this offering. We and the representatives of the underwriters will determine the initial public offering price. The price at which our common stock will trade after this offering is likely to be highly volatile and may fluctuate substantially due to a number of factors, in addition to our financial performance, such as: - industry announcements of technological innovations; - competitive trends, including timely adoption and market acceptance of, competing standards; - introduction of new technologies by us or our competitors; - developments related to intellectual property rights; - conditions and trends in the semiconductor industry; and - market perception of our growth prospects. In addition, the stock market has from time to time experienced significant price and volume fluctuations that have affected the market prices for the common stock of technology companies. These broad market fluctuations may result in a material decline in the market price of our common stock. In the past, following periods of volatility in the market price of a particular company's securities, securities class action litigation has often been brought against that company. We may become involved in this type of litigation in the future. Litigation is often expensive and diverts management's attention and resources that are needed to successfully run our business. INVESTORS IN OUR COMMON STOCK WILL EXPERIENCE IMMEDIATE AND SUBSTANTIAL DILUTION FOLLOWING THIS OFFERING. If you purchase shares of our common stock in this offering, you will incur immediate and substantial dilution in pro forma net tangible book value of $8.87. If the holders of outstanding options and warrants exercise those options and warrants, you will incur further dilution. See "Dilution."

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+RISK FACTORS Any investment in our common stock involves a high degree of risk. You should consider carefully the following information about these risks, together with the other information contained in this prospectus, before you decide whether to buy our common stock. Risks Related to Our Business We have had recent losses and will incur substantial future losses that may depress our stock price We have incurred significant losses since 1997, including losses of approximately $601,000, $3.6 million, and $26.4 million for the years ended December 31, 1997, 1998, and 1999, respectively. Our losses have resulted in an accumulated deficit of approximately $33.8 million as of December 31, 1999. We expect to substantially increase our sales and marketing, research and development, and general and administrative expenses. We anticipate incurring substantial losses for the next several years. As a result, we will need to generate significant additional revenues to achieve and maintain profitability in the future. Any significant shortfall of revenues in relation to our expectations or any material delay in client licenses would have an immediate adverse effect on our business. We are not certain when we will become profitable. Even if we do achieve profitability, we may not sustain or increase profitability on a quarterly or annual basis. Failure to achieve or maintain profitability will materially and adversely affect the market price of our common stock. We expect our quarterly revenues and operating results to fluctuate and the price of our common stock could fall if quarterly results are lower than expectations Our revenues and operating results are likely to vary significantly from quarter to quarter. The factors that will affect our quarterly operating results include: . fluctuations in demand for our products and services; . the timing of our application software and services sales; . the timing of our application software implementations; . increased expenditures for sales and marketing, research and development, and administration; . the timing and introduction of new software by us or our competitors; and . the mix of services provided, and whether we or our channel partners provide these services. If revenue falls below our expectations in a quarter and we are not able to quickly reduce our spending in response, our operating results for that quarter could be harmed. It is likely that in some future quarter our operating results may be below the expectations of public market analysts and investors and, as a result, the price of our common stock may fall. We have over 40 clients but currently only 14 clients have licensed our application software, and our Internet commerce solution may never achieve broad market acceptance, reducing potential for revenue growth We first introduced the XML-based version of OneCommerce in April 1999 and delivered a second major release in November 1999. Of our 40 clients, only 14 clients have licensed OneCommerce and of those, only three are operational on the most recent version. Therefore, we have not demonstrated broad market acceptance of OneCommerce. If OneCommerce does not gain broad market acceptance, or if OneCommerce fails to meet customer expectations, our business would be harmed. A large portion of our revenues are currently derived from five clients and a loss of one or more of these clients could cause our results of operations to suffer Five of our clients accounted for 71% of our revenues for the year ended December 31, 1998. Four clients accounted for 20.2%, 18.3%, 12.8%, and 12.2% each, respectively. Five of our clients accounted for an aggregate of 57% of our revenues for the year ended December 31, 1999. Three of those clients accounted for 18.5%, 12.7%, and 11.7% each, respectively. Although we believe that our client concentration will decrease as we continue to build our client base, we expect that a small number of clients will continue to account for a substantial portion of revenues in the near term. As a result, our inability to secure additional significant clients during a given period or the loss of any one major client could adversely affect our business. In addition, many of our clients are Internet start-up companies with limited resources. Accordingly, the non-payment of amounts due to us from a significant client could cause us to incur a bad debt expense which could cause our financial condition to suffer. For the year ended December 31, 1999, our bad debt expense was approximately $1.1 million. We may experience higher levels of bad debt expense in the future. All of our revenues are directly related to a single family of relatively new applications with few clients to date, and our revenue growth will be limited if these offerings are not commercially successful Our OneCommerce family of application services and related professional services account for substantially all of our revenues to date, and we expect these application services and professional services to continue to account for most of our revenues for the foreseeable future. We have over 40 clients, for both application services and professional services. If our current limited offerings are not commercially successful, our revenues will not increase as anticipated. We may not successfully develop or market any enhanced or new application services in the future, which would limit our ability to increase revenues. In the emerging marketplace of Internet commerce, our application services and professional services involve a new approach to the conduct of online business. As a result, intensive marketing and sales efforts may be necessary to educate prospective clients regarding the uses and benefits of our application services and our professional services, thereby generating demand. Companies that have already invested substantial resources in other methods of conducting business may be reluctant to adopt a new approach that may replace, limit, or compete with their existing systems. Accordingly, a viable market for our application services and professional services may not emerge or be sustainable. We anticipate the need to raise additional capital in the future, and if we cannot meet future capital requirements, we may not be able to conduct our business as planned We currently anticipate that the net proceeds from this offering, together with our existing working capital will be sufficient to meet our anticipated working capital and capital expenditure requirements through at least the next 12 months. The time period for which we believe our capital is sufficient is an estimate; the actual time period may differ materially as a result of a number of factors, risks, and uncertainties which are described herein. We may need to raise additional funds in the future through public or private debt or equity financings in order to: . continue rapid expansion of our business; . acquire complementary businesses or technologies; . develop new products or services; or . respond to competitive pressures. Additional financing may not be available on terms favorable to us, if at all. If adequate funds are not available or are not available on acceptable terms, we will not be able to take advantage of opportunities, develop new products or services, or otherwise respond to unanticipated competitive pressures. In such case, our business could be harmed. Growth in our operation has strained and will continue to strain our resources; our failure to manage growth effectively could negatively impact our revenue growth From January 1, 1999 to February 29, 2000, we grew from 72 to 300 employees and we intend to continue to grow. If we are successful, this growth will place a significant strain on the ability of our management team to execute our business plan. In addition, significant investments in personnel, management systems, and resources will be required. There will also be significant additional administrative burdens placed on our management team as a result of our status as a public company. We are upgrading our financial accounting and planning systems, our project management systems, our sales force automation systems, and installing a new customer relationship management system. The installation and incorporation of these systems into our management processes will place a significant burden on our management team and our information technology staff, and these systems may not be effective once implemented. If we do not manage this growth effectively, our business will suffer. We depend on our key personnel and we may not be able to fill other key management positions, which could disrupt our operations and result in reduced revenues Our performance is substantially dependent on the continued services and on the performance of our executive officers and other key employees, particularly James W. MacIntyre, IV, our chief executive officer, John L. Wyatt, our president and chief operating officer, Frederick C. Hawkins, III, our chief strategy officer and acting chief financial officer, and Thomas E. Young, our senior vice president of marketing and sales. Shortly after this offering, we will be launching an active search for a permanent chief financial officer. The loss of the services of any of our key employees, or an inability to hire other key members of management could materially and adversely affect our business. Our average sales cycle is four months, which makes our quarterly results difficult to forecast accurately Our application services and professional services are complex and often involve significant investment decisions by prospective clients. As a result, our average sales process frequently takes four months for reasons which include the following: . prospective clients often evaluate several possible alternative solutions from other software vendors, systems integrators, and internal development efforts; . we typically must extensively educate the potential client about our Internet commerce solution; and . our clients frequently must seek multiple internal approvals to reach a purchase decision due to the key role Internet commerce solutions may play in their business. Our sales cycle may be subject to a number of significant delays over which we have little or no control. Our long sales cycle makes it difficult for us to predict the quarter in which we will complete a particular sale. Because of sales delays, our revenues and operating results may vary from period to period. As a result, period-to-period comparisons of our results of operations may not be meaningful, and you should not rely on them as an indication of future performance. The Internet commerce market for our application software and services is new and rapidly developing and may fail to mature into a sustainable market, which would limit our ability to grow The Internet commerce market is new and rapidly evolving. It is not clear whether the developing infrastructure will be adequate to support increased Internet commerce, or whether our customers will be successful in using our application software and services to conduct their commercial operations online. Consequently, the demand for our application services and professional services in the Internet commerce market is uncertain. Our business will suffer if our application services and professional services are not widely accepted in the Internet commerce software market. If broad market acceptance of eXtensible Markup Language does not develop, our revenue growth could be negatively affected OneCommerce is currently based in large part on eXtensible Markup Language, or XML, an emerging technology standard for sharing data. It is possible that a competing standard perceived to be superior could replace XML. If that happens, the market may not accept an XML-based application and our future results would suffer. If a new standard were perceived to be superior, our application software might not be compatible with the new standard or we might not be able to develop a product using a new standard in a timely manner. Consequently, a failure of XML to achieve broad market acceptance or the introduction of a competing standard perceived to be superior in the market could harm our business. Market acceptance of OneCommerce is dependent on the acceptance and use of Microsoft operating systems and Internet technologies We designed OneCommerce to run only on Microsoft operating systems and Internet technologies. However, to date a majority of large-scale Internet commerce sites have used other operating systems such as UNIX or Linux. We cannot be certain that Microsoft operating systems and Internet technologies will achieve wide market acceptance as an easily scalable operating platform for large-scale Internet commerce solutions. If a significant number of potential clients do not want to use Microsoft operating systems and Internet technologies, we will be forced to develop products that run on other operating systems or Internet servers. Development of a new product line would require significant expenditures of time and money. Moreover, any change to Microsoft operating systems or Internet technologies could require us to modify our application services and could cause us to delay upgrades and releases. Any decline in the market acceptance of Microsoft operating systems and Internet technologies for any reason, including as a result of errors or delayed introduction of enhancement or upgrades, could harm our business. If we are forced to develop new application services in response to these risks, we will be required to commit a substantial investment of resources, and we may not be able to successfully develop or introduce new applications on a timely or cost-effective basis, or at all, which could lead potential customers to choose alternatives to our solution. We are dependent on marketing, technology, and distribution relationships, and if these relationships are not successful, our growth may be limited We rely on marketing, technology, and distribution relationships with a variety of companies, which, in part, generate leads for the sale of our Internet commerce application services. These relationships include: . vendors of key technology platforms; . systems integrators and consulting firms; . vendors of complementary Internet commerce software; and . application service providers. Not all of our channel partner and alliance partner relationships are documented in writing, and some are governed by agreements that can be terminated by either party with little or no prior notice. We may not be able to maintain these relationships or enter into new relationships that will provide timely and cost-effective distribution of OneCommerce. Moreover, these relationships are not exclusive. If the partners with whom we have relationships are not successful in selling and implementing systems that include our application services, or if they more vigorously promote competing solutions or technologies, our growth could be adversely affected. We may fail to establish and maintain beneficial strategic relationships, which would limit our revenue growth We intend to establish additional strategic relationships with key participants in the Internet commerce industry to increase our application software and services sales. There is intense competition for these relationships, and we may not be able to enter into these relationships on commercially reasonable terms or at all. In the event of a dispute among potential partners, it is possible that we could be drawn into litigation aimed at preventing us from continuing our relationship with either party. Even if we enter into relationships with other Internet commerce vendors, they themselves may not attract significant numbers of customers. Accordingly, we may not realize additional sales from these relationships. Moreover, we may have to expend significant resources to establish these relationships. Our inability to enter into new strategic relationships and expand our existing ones could harm our business and limit our growth. We face intense competition, which could adversely affect our sales and profitability The Internet commerce application software and professional services market is intensely competitive, highly fragmented, characterized by rapid technological change, and significantly affected by new product and service introductions. Recent acquisitions of several of our competitors by large software companies and other market activities of industry participants have increased the competition in our market. We may not be able to compete successfully against current or future competitors. We compete with other Internet commerce software vendors including Art Technology Group, BroadVision, OpenMarket, Vignette, InterWorld, and others. We also compete with application server products and their vendors including IBM and its Websphere products, the Sun-Netscape Alliance and its products, and Allaire Corporation and its products, among others. A number of these competitors have significantly greater financial, technical, marketing, and other resources than we have and have been in business longer than we have. Many competitors also have greater brand recognition and more customers than we do. Competitors may therefore have the capability to support marketing endeavors that are more extensive than ours or to adopt pricing and terms that are more aggressive than ours. Many of our key personnel are new to our company and may not work together successfully causing internal distractions from the development of our business A number of people on our management team and sales force have joined OneSoft in the last 12 months. Our management team has limited experience working together. For example, our president and chief operating officer joined us on March 15, 2000. Our future performance will depend, in part, on our ability to integrate successfully our newly hired executive officers into our management team, and our ability to develop an effective working relationship among management. Our executive officers, who have worked together for only a short time, may not be successful in working together or managing our company. Any disaffection or disaccord among executive officers, or between our officers and our board of directors, could affect our ability to make strategic decisions. In addition, we are rapidly hiring sales personnel with limited experience marketing our services and working with our sales force. If our key personnel are unable to market our services and work together successfully, it could have a negative effect on our ability to grow. Competition for employees in our industry, and in our geographic region, is intense, and we may not be able to hire or retain employees We believe we will need to attract, retain, and motivate talented management and other highly skilled employees to be successful. Competition for skilled personnel in our industry and in our geographic region is intense. If we are unable to retain our key employees or attract, assimilate, or retain other highly qualified employees in the future, the growth of our business will not meet future expectations. If we fail to develop new products and services in the face of our industry's rapidly evolving technology, our future results may be adversely affected The market for Internet commerce application software and related services is subject to rapid technological change, changing customer needs, frequent new product introductions, and evolving industry standards that may render existing applications and services obsolete. Our growth and future operating results will depend in part upon our ability to enhance existing applications and develop and introduce new application software or components that: . exploit technological advances in the marketplace; . meet changing customer requirements; . achieve market acceptance; . integrate successfully with third party software; and . respond to competitive products. Our research and development efforts have required, and are expected to continue to require, substantial investment. We may not possess sufficient resources to continue to make the necessary investments in technology. In addition, we may not successfully identify new software opportunities and develop and bring new software to market in a timely and efficient manner. If we are unable, for technological or other reasons, to develop and introduce new and enhanced software in a timely manner, we may lose existing customers and fail to attract new customers, which could result in a decline in revenues. Our application software may contain defects, which can result in reduced sales, increased service and warranty costs, and liability to our clients and claims against us Our application software may contain errors that become apparent when they are introduced or when the volume of usage increases. Errors in our software, implementation errors, including those caused by third parties, or other performance difficulties could result in decreased sales of our software, increased service and warranty costs, and liability to our clients, which could have an adverse effect on our business. Although we carry errors and omissions insurance, such insurance may not cover all liability claims made against us. Our risk of liability to clients is particularly pronounced because of our belief that our application software will be critical to their operations. Intellectual property claims against us can be costly and result in the loss of significant rights if we are not successful in defending those claims Other parties may assert infringement or unfair competition claims against us. Any claim, with or without merit, could result in significant litigation costs and distraction of management. Some of our competitors have been issued U.S. patents on certain aspects of their electronic commerce software products. Although we do not believe that we are infringing on any such patent rights, those companies may claim that we are doing so. If any such claim was made against us, our business could be harmed, particularly if we are unsuccessful in defending such claim. If we are forced to defend any such claim, whether it is with or without merit or is determined in our favor, then we may face costly litigation, diversion of technical and management personnel, or delays in future application software releases. We may also be required to enter into costly and burdensome royalty and licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us, or at all. We have received correspondence from attorneys representing our former chief technology officer, asserting that he invented a portion of the technology incorporated in our pending patent application and that our use of any of this technology infringes on his ownership rights. Should litigation arise from this matter, the results are unpredictable, and we cannot guarantee that we will preserve the right to use the proprietary technology asserted to be owned by the former employee. If we are precluded from using this technology or are found to be infringing the former employee's proprietary rights, our business could be materially damaged. See "Business--Intellectual Property and Proprietary Rights." We rely on our intellectual property rights and if we are unable to protect these rights, we may face increased competition We rely on a combination of patent, copyright, trademark, and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We have applied to register 95 trademarks in the United States, including "OneSoft", "OneCommerce", "PrimeCommerce", and "Internet Commerce Opportunity Assessment", among others. We also have filed a patent application claiming proprietary inventions used in our software architecture. We cannot be certain that trademark registrations or patents will issue from these applications. Moreover, even if they do, unauthorized persons may attempt to copy or otherwise obtain and use our intellectual property. Monitoring unauthorized use of our intellectual property is difficult, and we cannot be certain that the steps we have taken will be effective to prevent unauthorized use. In addition, our business activities may infringe on the proprietary rights of others, and, from time to time, we have received and may continue to receive, claims of infringement against us. Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets, or to determine the validity and scope of the proprietary rights of others. Litigation could subject us to significant liability for damages and invalidation of our proprietary rights. These lawsuits, regardless of their success, would likely be time consuming and expensive to resolve, and would divert management's time and attention away from our business. We generally enter into confidentiality or license agreements with our employees and consultants, and control access to and distribution of our intellectual property, documentation, and other proprietary information. Despite our efforts to protect our proprietary rights from unauthorized use or disclosure, unauthorized parties may attempt to disclose, obtain, or use our solutions or intellectual property. We cannot assure you that the steps we have taken will prevent misappropriation of our solutions or intellectual property, particularly in foreign countries where laws or law enforcement practices may not protect our proprietary rights as fully as in the United States. Acquisitions may disrupt or otherwise have a negative impact on our business We may acquire or make investments in complementary businesses, products, services, or technologies on an opportunistic basis when they will assist us in carrying out our business strategy. Growth through acquisitions has been a successful strategy used by other technology companies. We do not have any present understanding, nor are we conducting any negotiations, relating to any such acquisition or investment. If we acquire a company, then we could have difficulty in assimilating that company's personnel and operations. In addition, the key personnel of the acquired company may decide not to work for us. If we acquire products, services or technologies, we could have difficulty in assimilating them into our operations. These difficulties could disrupt our ongoing business, distract our management and employees, and increase our expenses. Furthermore, we may have to incur debt or issue equity securities to pay for any future acquisitions, the issuance of which could be dilutive to our existing stockholders. In addition, these securities may have rights, preferences, or privileges senior to those of our existing stockholders. We intend to expand our international sales efforts but do not have substantial experience in international markets, therefore, we may not be successful and such failures could have an adverse effect on our revenues We intend to expand our international sales efforts in the future. We have limited experience in marketing, selling, and supporting our application software and services abroad. Expansion of our international operations will require a significant amount of attention from our management and substantial financial resources. If we are unable to grow our international operations successfully and in a timely manner, our business could suffer. Doing business internationally involves additional risks, particularly: . unexpected changes in regulatory requirements, taxes, trade laws, and tariffs; . restrictions on repatriation of earnings; . differing intellectual property rights and protections; . differing labor regulations; . political and economic uncertainty or instability in some regions; . greater difficulty in staffing and managing foreign operations; and . fluctuating currency exchange rates. Risks Related to Our Industry We depend on the growth in the use of the Internet for business, which is not certain Our future success depends heavily on the increased use of the Internet for business. Although the Internet is experiencing rapid growth in the number of users and traffic, this growth is a recent phenomenon and may not continue. The failure of the Internet to continue to grow and develop as a commercial or business medium could harm our business. The acceptance and use of the Internet for commerce could be limited by a number of factors such as the growth and use of the Internet in general, the relative ease of conducting transactions on the Internet, concerns about transaction security, and taxation of transactions on the Internet. We depend on the speed and reliability of the Internet to enable the growth of Internet commerce, which may not develop The recent growth in Internet traffic has caused frequent periods of decreased performance. If Internet usage continues to grow rapidly, its infrastructure may not be able to support these demands and its performance and reliability may decline. If outages or delays on the Internet occur frequently or increase in frequency, Internet commerce could grow more slowly or decline, which may reduce the demand for our Internet software application services. The ability of OneCommerce and our professional services to satisfy our clients' needs is ultimately limited by and depends upon the speed and reliability of the Internet. Consequently, the emergence and growth of the market for our application services and related professional services depends upon improvements being made to the entire Internet infrastructure to alleviate overloading and congestion. If these improvements are not made, the ability of our clients to utilize our solutions will be hindered, and our business may suffer. Breaches of security on the Internet may slow the growth of Internet commerce, limit our growth, and expose us to liability A significant barrier to market acceptance of Internet commerce and communication is the concern regarding the secure exchange of valuable and confidential information over public networks. Anyone who is able to circumvent security measures could misappropriate proprietary, confidential customer information or cause interruptions in our clients' operations. Our clients may be required to incur significant costs to protect against security breaches or to alleviate problems caused by breaches, reducing their demand for our application services. A well-publicized breach of security could deter consumers and businesses from using the Internet to conduct transactions that involve transmitting confidential information. The failure of the security features of our application software to prevent security breaches, or well- publicized security breaches affecting the Web in general, could significantly harm our business. Unplanned system interruptions and capacity constraints could reduce our ability to provide hosting services and could harm our business and our reputation Our clients have in the past experienced some interruptions with our hosted network. We believe that these interruptions will continue to occur from time to time. These interruptions could be due to hardware and operating system failures. We expect a substantial portion of our revenues to be derived from customers who use our hosted network. As a result, our business will suffer if we experience frequent or long system interruptions that result in the unavailability or reduced performance of our hosted network or reduce our ability to provide remote management services. We expect to experience occasional temporary capacity constraints due to sharply increased traffic, which may cause unanticipated system disruptions, slower response times, impaired quality, and degradation in levels of customer service. If this were to continue to happen, our business and reputation could be seriously harmed. Our success largely depends on the efficient and uninterrupted operation of our computer and communications hardware and network systems. Substantially all of our computer communications systems are located in Northern Virginia. Our systems and operations are vulnerable to damage or interruption from fire, earthquake, power loss, telecommunications failure and similar events. We have entered into service agreements with some of our clients that require minimum performance standards, including standards regarding the availability and response time of our remote management services. If we fail to meet these standards, our clients could terminate their relationships with us and we could be subject to contractual monetary penalties. Any unplanned interruption of services may harm our ability to attract and retain clients. We rely on relationships with, and the system integrity of, our hosting partners Some of our hosted network consists of data centers hosted by our partners. Accordingly, we rely on the speed and reliability of the systems and networks of these hosting partners. If our hosting partners experience system interruptions or delays or other problems, or if we do not maintain or develop relationships with hosting partners, our business could suffer. Increasing governmental regulation and legal uncertainties surrounding the Internet and Internet commerce could limit the market for our products A number of legislative and regulatory proposals under consideration by federal, state, local, and foreign governmental organizations may lead to laws or regulations concerning various aspects of the Internet such as taxation of goods and services provided over the Internet, pricing, content, and quality of goods and services. Legislation and anticipated legislation could dampen the growth in Internet usage and decrease or limit its acceptance as a communications and commercial medium. If enacted, these laws and regulations could limit the market for our products and services. In addition, existing laws could be applied to the Internet. Legislation or application of existing laws could expose companies involved in Internet commerce to increased liability, which could limit the growth of Internet commerce generally, and limit demand for our application software and services, in particular. Government regulation of the collection and use of personal data could reduce demand for our products and services by impairing the ability of businesses to obtain information about customers using the features of OneCommerce Our Internet application software connects to and analyzes data from various applications, including Internet applications, which enable businesses to capture and use information about their customers. Government regulation that limits our clients' use of this information could reduce the demand for our products. A number of jurisdictions have adopted, or are considering adopting, laws that restrict the use of customer information from Internet applications. The European Union has required that its member states adopt legislation that imposes restrictions on the collection and use of personal data on the Internet. They also must adopt legislation limiting the transfer of personally- identifiable data to countries that do not impose equivalent restrictions. The United States Department of Commerce and the European Union are negotiating safe-harbor regulations for U.S.-based Internet commerce companies, but have not yet reached agreement. In the United States, the Children's Online Privacy Protection Act was enacted in October 1998. The Federal Trade Commission has enacted rules implementing this legislation which imposes disclosure obligations on Internet sites collecting personally-identifiable data from children under the age of 13. These rules become effective in April. In addition, the Federal Trade Commission is investigating privacy practices of businesses that collect information on the Internet. These and other privacy- related initiatives could reduce demand for some of the Internet applications with which OneCommerce operates, and could restrict the use of some of the features of OneCommerce in some Internet commerce applications. Either scenario could potentially result in reduced demand for our application software and services. Risks Related to This Offering Internet-related stock prices are especially volatile and this volatility may depress our stock price and negatively impact your investment The stock market, and specifically the stock prices of Internet-related companies, has been very volatile. This volatility is often not related to the operating performance of the companies. This broad market volatility and industry volatility may reduce the price of our common stock, without regard to our operating performance. Investors may not be able to resell their shares of our common stock following periods of volatility because of the market's adverse reaction to such volatility. Securities class action litigation has often been brought against companies experiencing volatility in the market price of their securities. Litigation brought against us could result in substantial costs to us in defending against a lawsuit and management's attention could be diverted from our business. Because a group of existing stockholders owns a large percentage of our voting stock, other stockholders' voting power may be limited Following consummation of this offering, it is anticipated that our officers, directors, their affiliates, and entities owning 5.0% or more of our outstanding shares of common stock will beneficially own or control 13,769,865 shares of our common stock, or approximately 64.0% of the outstanding shares of our stock. As a result, if such persons act together, they will have the ability to control all matters submitted to our stockholders for approval, including election and removal of directors and the approval of any merger, consolidation, or sale of all or substantially all of our assets. These stockholders may make decisions that are adverse to your interests. See our discussion under the heading "Principal and Selling Stockholders" for more information about ownership of our outstanding shares. Management may apply the proceeds of this offering to uses that do not increase our profits or market value Our management has broad discretion as to how to spend the proceeds from this offering and may spend these proceeds in ways with which our stockholders may not agree. Our management has not determined how a substantial portion of the offering proceeds will be allocated among various uses. Accordingly, the net proceeds may be used for corporate purposes that do not increase our profitability or our market value. Until the proceeds are needed, we plan to invest them in investment-grade, interest-bearing securities. The failure of management to apply these proceeds effectively could harm our business. See "Use of Proceeds" for more information about how we plan to use our proceeds from this offering. Future sales of shares of our common stock could cause the price of our shares to decline If our shareholders sell substantial amounts of our common stock, including shares issued upon the exercise of outstanding options and warrants, in the public market following the offering, then the market price of our common stock could fall. Restrictions under the securities laws and certain lock-up agreements limit the number of shares of common stock available for sale in the public market. The holders of 15,392,480 shares of common stock and options for an aggregate of 1,750,500 shares of common stock have agreed not to sell any such securities for 180 days after the offering without the prior written consent of Deutsche Bank Securities Inc. However, Deutsche Bank Securities Inc. may, in its sole discretion, release all or any portion of the securities subject to such lock-up agreements. We may file a registration statement to register all shares of common stock under our stock option plans shortly after completion of this offering. After such registration statement is effective, shares issued upon exercise of stock options will be eligible for resale in the public market without restriction. Anti-takeover provisions and our right to issue preferred stock could make a third-party acquisition of us difficult We are a Delaware corporation. Anti-takeover provisions of Delaware law could make it more difficult for a third party to acquire control of us, even if such change in control would be beneficial to stockholders. Our amended and restated certificate of incorporation provides that our board of directors may issue preferred stock without shareholder approval. In addition, our amended and restated bylaws provide for a classified board, with each board member serving a staggered three-year term. The issuance of preferred stock, the existence of a classified board, and other provisions in the charter and under Delaware law could make it more difficult for a third party to acquire us. You will incur immediate and substantial dilution in the book value of your investment The initial public offering price is substantially higher than the pro forma net book value per share of our outstanding common stock. If you purchase shares of our common stock, you will incur immediate and substantial dilution in the amount of $9.58 per share. If the holders of outstanding options or warrants exercise those options or warrants, you will experience further dilution.

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+RISK FACTORS INVESTING IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. IN ADDITION TO THE OTHER INFORMATION IN THIS PROSPECTUS, YOU SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW BEFORE PURCHASING OUR COMMON STOCK. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCURS, OUR BUSINESS COULD BE MATERIALLY HARMED, AND OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS COULD BE MATERIALLY HARMED. AS A RESULT, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE, AND YOU MIGHT LOSE ALL OR PART OF YOUR INVESTMENT. RISKS RELATED TO THE DEVELOPMENT AND COMMERCIALIZATION OF OUR PRODUCTS OUR XENOMOUSE TECHNOLOGY MAY NOT PRODUCE SAFE, EFFICACIOUS OR COMMERCIALLY VIABLE PRODUCTS. Our XenoMouse technology is a new approach to the generation of antibody therapeutic products. We have not commercialized any antibody products based on XenoMouse technology. Moreover, we are not aware of any commercialized, fully human antibody therapeutic products that have been generated from any technologies similar to ours. Our antibody product candidates are still at an early stage of development. Clinical trials have begun with respect to only three fully human antibody product candidates generated by XenoMouse technology. We cannot be certain that XenoMouse technology will generate antibodies against all the antigens to which it is exposed in an efficient and timely manner, if at all. Furthermore, XenoMouse technology may not result in any meaningful benefits to our current or potential customers or be safe and efficacious for patients. If XenoMouse technology fails to generate antibody product candidates that lead to the successful development and commercialization of products, our business, financial condition and results of operations will be materially harmed. SUCCESSFUL DEVELOPMENT OF OUR PRODUCTS IS UNCERTAIN. Our development of current and future product candidates is subject to the risks of failure inherent in the development of new pharmaceutical products and products based on new technologies. These risks include: - delays in product development, clinical testing or manufacturing; - unplanned expenditures in product development, clinical testing or manufacturing; - failure in clinical trials or failure to receive regulatory approvals; - emergence of superior or equivalent products; - inability to manufacture on our own, or through others, product candidates on a commercial scale; - inability to market products due to third-party proprietary rights; - election by our customers not to pursue product development; - failure by our customers to develop products successfully; and - failure to achieve market acceptance. Because of these risks, our research and development efforts or those of our customers may not result in any commercially viable products. To date, our customers' right to obtain a product license has been exercised for only six product candidates. If a significant portion of these development efforts is not successfully completed, required regulatory approvals are not obtained or any approved products are not commercially successful, our business, financial condition and results of operations will be materially harmed. CLINICAL TRIALS FOR OUR PRODUCT CANDIDATES WILL BE EXPENSIVE AND THEIR OUTCOME IS UNCERTAIN. Conducting clinical trials is a lengthy, time-consuming and expensive process. Before obtaining regulatory approvals for the commercial sale of any products, we must demonstrate through pre-clinical testing and clinical trials that our product candidates are safe and effective for use in humans. We will incur substantial expense for, and devote a significant amount of time to, pre-clinical testing and clinical trials. Historically, the results from pre-clinical testing and early clinical trials have often not been predictive of results obtained in later clinical trials. A number of new drugs and biologics have shown promising results in clinical trials, but subsequently failed to establish sufficient safety and efficacy data to obtain necessary regulatory approvals. Data obtained from pre-clinical and clinical activities are susceptible to varying interpretations, which may delay, limit or prevent regulatory approval. In addition, regulatory delays or rejections may be encountered as a result of many factors, including changes in regulatory policy during the period of product development. As of November 9, 2000, three of our product candidates, ABX-CBL, ABX-IL8 and ABX-EGF, were in clinical trials. Patient follow-up for these clinical trials has been limited. To date, data obtained from these clinical trials has been insufficient to demonstrate safety and efficacy under applicable Federal Drug Administration, or FDA, guidelines. As a result, this data will not support an application for regulatory approval without further clinical trials. Clinical trials conducted by us or by third parties on our behalf may not demonstrate sufficient safety and efficacy to obtain the requisite regulatory approvals for ABX-CBL, ABX-IL8, ABX-EGF and/or any other potential product candidates. Regulatory authorities may not permit us to undertake any additional clinical trials for our product candidates. In addition, our other product candidates are in pre-clinical development, but we have not submitted investigational new drug applications nor begun clinical trials for these product candidates. Our pre-clinical or clinical development efforts may not be successfully completed, we may not file further investigational new drug applications and clinical trials may not commence as planned. Completion of clinical trials may take several years or more. The length of time generally varies substantially according to the type, complexity, novelty and intended use of the product candidate. Our commencement and rate of completion of clinical trials may be delayed by many factors, including: - inability to manufacture sufficient quantities of materials for use in clinical trials; - slower than expected rate of patient recruitment; - inability to adequately follow patients after treatment; - unforeseen safety issues; - lack of efficacy during the clinical trials; or - government or regulatory delays. We have limited experience in conducting and managing clinical trials. We rely on third parties, including our customers, to assist us in managing and monitoring clinical trials. Our reliance on these third parties may result in delays in completing, or failing to complete, these trials if the third parties fail to perform under our agreements with them. Our product candidates may fail to demonstrate safety and efficacy in clinical trials. This failure may delay development of other product candidates and hinder our ability to conduct related pre-clinical testing and clinical trials. As a result of these failures, we may also be unable to obtain additional financing. Any delays in, or termination of, our clinical trials will materially harm our business, financial condition and results of operations. THE CLINICAL SUCCESS OF ABX-CBL IS UNCERTAIN. We recently completed a multi-center Phase II trial for the treatment of graft versus host disease, or GVHD, with our mouse antibody, ABX-CBL. As of October 11, 2000, ABX-CBL had been administered to a total of only 191 patients for GVHD and organ transplant rejection indications. ABX-CBL was administered to a total of 85 of these patients by third parties prior to the time we obtained an exclusive license to ABX-CBL. We cannot rely on data obtained from patients studied prior to our obtaining an exclusive license to ABX-CBL to support the efficacy of ABX-CBL in an application for regulatory approval. Data from 27 patients included in the Phase II study was submitted to the FDA. As an extension to the original Phase II trial protocol, we have enrolled an additional 32 patients. In December 1999, we initiated a multicenter randomized and controlled Phase II/III study comparing ABX-CBL to ATG(R). The study is designed to demonstrate statistically significant efficacy of a single dose level of ABX-CBL in comparison to a control group of patients receiving ATG(R). The results of the Phase II/ III trial may not be favorable or may not extend the findings of the original Phase II study. The FDA may view the result of our Phase III trial as insufficient and may require additional clinical trials. There are several issues that could adversely affect the clinical trial results, including the lack of a standard therapy for GVHD patients in the control group, unforeseen side effects, variability in the number and types of patients in the study and response rates required to achieve statistical significance in the study. In addition, our clinical trials are being conducted with patients who have failed conventional treatments and who are in the most advanced stages of GVHD. During the course of treatment, these patients can die or suffer adverse medical effects for reasons that may not be related to ABX-CBL. These adverse effects may affect the interpretation of clinical trial results. There is a risk that the FDA will not accept the results of the Phase II/III study or other elements of the product license application as being sufficient for approval to market. Additional clinical trials will be extensive, expensive and time-consuming. If ABX-CBL fails to receive regulatory approval, our business, financial condition and results of operations may be materially harmed. WE CURRENTLY RELY ON A SOLE SOURCE THIRD-PARTY MANUFACTURER. We currently rely, and will continue to rely for at least the next two years, on a sole source third-party manufacturer to produce ABX-CBL, ABX-IL8 and ABX-EGF under good manufacturing practice regulations, for use in our clinical trials. Our third-party manufacturer has a limited number of facilities in which our product candidates can be produced and has limited experience in manufacturing ABX-CBL, ABX-IL8 and ABX-EGF in quantities sufficient for conducting clinical trials or for commercialization. We currently rely on our third-party manufacturer to produce our product candidates under good manufacturing practice regulations, which meet acceptable standards for our clinical trials. Third-party manufacturers often encounter difficulties in scaling up production, including problems involving production yields, quality control and assurance, shortage of qualified personnel, compliance with FDA regulations, production costs, and development of advanced manufacturing techniques and process controls. Our third-party manufacturer may not perform as agreed or may not remain in the contract manufacturing business for the time required by us to successfully produce and market our product candidates. If our third-party manufacturer fails to deliver the required quantities of our product candidates for clinical use on a timely basis and at commercially reasonable prices, and we fail to find a replacement manufacturer or develop our own manufacturing capabilities, our business, financial condition and results of operations will be materially harmed. OUR OWN ABILITY TO MANUFACTURE IS UNCERTAIN. We are in the planning stages of establishing our own pilot scale manufacturing facility for the manufacture of products for Phase I and Phase II clinical trials, in compliance with FDA good manufacturing practices. In May 2000, we signed a long-term lease for a building to be built to contain this pilot scale facility. Construction schedules for this facility may take longer than expected, and the planned and actual construction costs of building and qualifying the facility for regulatory compliance may be higher than expected. The process of manufacturing antibody products is complex. We have no experience in the clinical or commercial scale manufacturing of ABX-CBL, ABX-IL8 and ABX-EGF, or any other antibody products. Such antibody products will also need to be manufactured in a facility and by a process which complies with FDA and other regulations. It may take a substantial period of time to begin producing antibodies in compliance with such regulations. Our manufacturing operations will be subject to ongoing, periodic unannounced inspection by the FDA and state agencies to ensure compliance with good manufacturing practices. If we are unable to establish and maintain a manufacturing facility within our planned time and cost parameters, the development and sales of our products and our financial performance may be materially harmed. We also may encounter problems with the following: - production yields; - quality control and assurance; - shortages of qualified personnel; - compliance with FDA regulations; - production costs; and - development of advanced manufacturing techniques and process controls. We are currently evaluating our options for Phase III clinical trial supplies and commercial production of our antibody products, which include use of third-party manufacturers, establishing our own commercial scale manufacturing facility or entering into a manufacturing joint venture relationship with a third party. We are aware of only a limited number of companies on a worldwide basis who operate manufacturing facilities in which our product candidates can be manufactured under good manufacturing practice regulations, a requirement for all pharmaceutical products. It would take a substantial period of time for a contract facility which has not been producing antibodies to begin producing antibodies under good manufacturing practice regulations. We cannot assure you that we will be able to contract with any of these companies on acceptable terms, if at all. In addition, we and any third-party manufacturer will be required to register manufacturing facilities with the FDA and other regulatory authorities. The facilities will then be subject to inspections confirming compliance with FDA good manufacturing practice or other regulations. If we or any of our third-party manufacturers fail to maintain regulatory compliance, our business, financial condition and results of operations will be materially harmed. WE WILL NEED TO FIND THIRD PARTIES TO LICENSE AND DEVELOP MANY OF OUR PRODUCT CANDIDATES. Our strategy for the development and commercialization of antibody therapeutic products depends, in large part, upon the formation of collaboration agreements with third parties. Potential third parties include pharmaceutical and biotechnology companies, academic institutions and other entities. We must enter into these agreements to successfully develop and commercialize product candidates. These agreements are necessary in order for us to: - access proprietary antigens for which we can generate fully human antibody products; - fund our research and development activities; - fund pre-clinical development, clinical trials and manufacturing; - seek and obtain regulatory approvals; and - successfully commercialize existing and future product candidates. Only a limited number of fully human antibody product candidates have been generated pursuant to our collaboration agreements, and only three antibody product candidates generated with XenoMouse technology have entered clinical testing. We cannot assure you that any of these product candidates will result in commercially successful products. Current or future collaboration agreements may not be successful. If we fail to maintain our existing collaboration agreements or to enter into additional agreements, our business, financial condition and results of operations will be materially harmed. Our dependence on licensing and other agreements with third parties subjects us to a number of risks. These agreements may not be on terms favorable to us, and collaborators typically are afforded significant discretion in electing whether to pursue any of the planned activities. We cannot control the amount and timing of resources our collaborators may devote to the product candidates, and collaborators may not perform their obligations as expected. Additionally, business combinations or significant changes in a collaborator's business strategy may adversely affect a collaborator's willingness or ability to complete its obligations under the arrangement. Even if we fulfill our obligations under an agreement, typically our collaborators can terminate the agreement at any time following proper written notice. If any of our collaborators were to terminate or breach our agreement, or otherwise fail to complete its obligations in a timely manner, our business, financial condition and results of operations may be materially harmed. If we are not able to establish further collaboration agreements or any or all of our existing agreements are terminated, we may be required to seek new collaborators or to undertake product development and commercialization at our own expense. Such an undertaking may: - limit the number of product candidates that we will be able to develop and commercialize; - reduce the likelihood of successful product introduction; - significantly increase our capital requirements; and - place additional strain on our management's time. Existing or future collaborators may pursue alternative technologies, including those of our competitors. Disputes may arise with respect to the ownership of rights to any technology or products developed with any current or future collaborator. Lengthy negotiations with potential new collaborators or disagreements between us and our collaborators may lead to delays or termination in the research, development or commercialization of product candidates or result in time-consuming and expensive litigation or arbitration. If our collaborators pursue alternative technologies or fail to develop or commercialize successfully any product candidate to which they have obtained rights from us, our business, financial condition and results of operations may be materially harmed. WE DO NOT HAVE MARKETING AND SALES EXPERIENCE. We do not have marketing, sales or distribution capability. For certain products, we may establish an internal marketing and sales force. We intend to enter into arrangements with third parties to market and sell most of our products. We may not be able to enter into marketing and sales arrangements with others on acceptable terms, if at all. To the extent that we enter into marketing and sales arrangements with other companies, our revenues, if any, will depend on the efforts of others. These efforts may not be successful. If we are unable to enter into third-party arrangements, then we must develop a marketing and sales force, which may need to be substantial in size, in order to achieve commercial success for any product candidate approved by the FDA. We may not successfully develop marketing and sales experience or have sufficient resources to do so. If we do develop such capabilities, we will compete with other companies that have experienced and well-funded marketing and sales operations. If we fail to establish successful marketing and sales capabilities or fail to enter into successful marketing arrangements with third parties, our business, financial condition and results of operations will be materially harmed. WE ARE SUBJECT TO EXTENSIVE GOVERNMENT REGULATIONS AND WE MAY NOT BE ABLE TO OBTAIN REGULATORY APPROVALS. Our product candidates under development are subject to extensive and rigorous domestic government regulation. The FDA regulates, among other things, the development, testing, manufacture, safety, efficacy, record-keeping, labeling, storage, approval, advertising, promotion, sale and distribution of biopharmaceutical products. If our products are marketed abroad, they also are subject to extensive regulation by foreign governments. None of our product candidates has been approved for sale in the United States or any foreign market. The regulatory review and approval process, which includes pre-clinical studies and clinical trials of each product candidate, is lengthy, expensive and uncertain. Securing FDA approval requires the submission of extensive pre-clinical and clinical data and supporting information to the FDA for each indication to establish the product candidates' safety and efficacy. The approval process takes many years, requires the expenditure of substantial resources, involves post-marketing surveillance, and may involve ongoing requirements for post-marketing studies. Delays in obtaining regulatory approvals may: - adversely affect the successful commercialization of any drugs that we or our customers develop; - impose costly procedures on us or our customers; - diminish any competitive advantages that we or our customers may attain; and - adversely affect our receipt of revenues or royalties. Certain material changes to an approved product such as manufacturing changes or additional labeling claims are subject to further FDA review and approval. Any required approvals, once obtained, may be withdrawn. Compliance with other regulatory requirements may not be maintained. Further, if we fail to comply with applicable FDA and other regulatory requirements at any stage during the regulatory process, we or our third-party manufacturers may be subject to sanctions, including: - delays; - warning letters; - fines; - product recalls or seizures; - injunctions; - refusal of the FDA to review pending market approval applications or supplements to approval applications; - total or partial suspension of production; - civil penalties; - withdrawals of previously approved marketing applications; and - criminal prosecutions. We expect to rely on our customers to file investigational new drug applications and generally direct the regulatory approval process for many of our products. Our customers may not be able to conduct clinical testing or obtain necessary approvals from the FDA or other regulatory authorities for any product candidates. If we fail to obtain required governmental approvals, our customers will experience delays in or be precluded from marketing products developed through our research. In addition, the commercial use of our products will be limited. Delays and limitations may materially harm our business, financial condition and results of operations. We and our third-party manufacturers also are required to comply with the applicable FDA current good manufacturing practice regulations. Good manufacturing practice regulations include requirements relating to quality control and quality assurance as well as the corresponding maintenance of records and documentation. Manufacturing facilities are subject to inspection by the FDA. These facilities must be approved before we can use them in commercial manufacturing of our products. We or our third-party manufacturers may not be able to comply with the applicable good manufacturing practice requirements and other FDA regulatory requirements. If we or our third-party manufacturers fail to comply, our business, financial condition and results of operations will be materially harmed. MARKET ACCEPTANCE OF OUR PRODUCTS IS UNCERTAIN. Our product candidates may not gain market acceptance among physicians, patients, healthcare payors and the medical community. We may not achieve market acceptance even if clinical trials demonstrate safety and efficacy, and the necessary regulatory and reimbursement approvals are obtained. The degree of market acceptance of any product candidates that we develop will depend on a number of factors, including: - establishment and demonstration of clinical efficacy and safety; - cost-effectiveness of our product candidates; - their potential advantage over alternative treatment methods; - reimbursement policies of government and third-party payors; and - marketing and distribution support for our product candidates. Physicians will not recommend therapies using our products until such time as clinical data or other factors demonstrate the safety and efficacy of such procedures as compared to conventional drug and other treatments. Even if the clinical safety and efficacy of therapies using our antibody products is established, physicians may elect not to recommend the therapies for any number of other reasons, including whether the mode of administration of our antibody products is effective for certain indications. For example, antibody products are typically administered by infusion or injection, which requires substantial cost and inconvenience to patients. Our product candidates, if successfully developed, will compete with a number of drugs and therapies manufactured and marketed by major pharmaceutical and other biotechnology companies. Our products may also compete with new products currently under development by others. Physicians, patients, third-party payors and the medical community may not accept and utilize any product candidates that we or our customers develop. If our products do not achieve significant market acceptance, our business, financial condition and results of operations will be materially harmed. RISKS RELATED TO OUR FINANCES WE ARE AN EARLY STAGE COMPANY. You must evaluate us in light of the uncertainties and complexities present in an early stage biopharmaceutical company. Our product candidates are in early stages of development. We will require significant additional investment in research and development, pre-clinical testing and clinical trials, regulatory and sales and marketing activities to commercialize current and future product candidates. Our product candidates, if successfully developed, may not generate sufficient or sustainable revenues to enable us to be profitable. WE HAVE A HISTORY OF LOSSES. We have incurred net losses in each of the last five years of operation, including net losses of approximately $8.3 million in 1995, $7.1 million in 1996, $35.9 million in 1997, $16.8 million in 1998, $20.5 million in 1999 and $4.3 million in the nine months ended September 30, 2000. As of September 30, 2000, our accumulated deficit was approximately $94.1 million. Our losses to date have resulted principally from: - research and development costs relating to the development of our XenoMouse technology and antibody product candidates; - costs associated with certain agreements with Japan Tobacco; - costs related to a cross-license and settlement agreement relating to our intellectual property portfolio; and - general and administrative costs relating to our operations. We expect to incur additional losses for the foreseeable future as a result of increases in our research and development costs, including costs associated with conducting pre-clinical development and clinical trials, and charges related to purchases of technology or other assets. We intend to invest significantly in our products prior to entering into licensing agreements. This may increase our need for capital and will result in losses for several years. We expect that the amount of operating losses will fluctuate significantly from quarter to quarter as a result of increases or decreases in our research and development efforts, the execution or termination of licensing and contractual agreements, or the initiation, success or failure of clinical trials. OUR FUTURE PROFITABILITY IS UNCERTAIN. Prior to June 1996, our business was owned by Cell Genesys, Inc. and operated as a business unit. Since that time, we have funded our research and development activities primarily from: - initial contributions from Cell Genesys; - private placements of our capital stock; - the initial public offering of our common stock; - the follow-on public offering of our common stock in 1999; - the follow-on public offering of our common stock in February 2000; - a private placement of our common stock in November 2000, which shares of common stock are to be registered by the registration statement of which this prospectus forms a part; - revenues generated from our licensing and contractual agreements; - equipment leaseline financings; and - loan facilities. We expect that substantially all of our revenues for the foreseeable future will result from payments under licensing and contractual agreements and interest income. To date, payments under licensing and contractual agreements have been in the form of option fees, reimbursement for research and development expenses, license fees and milestone payments. Payments under our existing and any future customer agreements will be subject to significant fluctuation in both timing and amount. Our revenues may not be indicative of our future performance or of our ability to continue to achieve such milestones. Our revenues and results of operations for any period may also not be comparable to the revenues or results of operations for any other period. We may not be able to: - enter into further licensing and contractual agreements; - successfully complete pre-clinical development or clinical trials; - obtain required regulatory approvals; - successfully develop, manufacture and market product candidates; or - generate additional revenues or profitability. If we fail to achieve any of the above goals, our business, financial condition and results of operations will be materially harmed. WE MAY REQUIRE ADDITIONAL FINANCING. We will continue to expend substantial resources for the expansion of research and development, including costs associated with conducting pre-clinical development and clinical trials. We will be required to expend substantial funds in the course of completing required additional development, pre-clinical testing and clinical trials of and regulatory approval for product candidates. Our future liquidity and capital requirements will depend on many factors, including: - the scope and results of pre-clinical development and clinical trials; - the retention of existing and establishment of further licensing and contractual agreements, if any; - continued scientific progress in our research and development programs; - the size and complexity of these programs; - the cost of establishing manufacturing capabilities and conducting commercialization activities and arrangements; - the time and expense involved in obtaining regulatory approvals, if any; - competing technological and market developments; - the time and expense of filing and prosecuting patent applications and enforcing patent claims; - investment in, or acquisition of, other companies; - product in-licensing; and - other factors not within our control. We believe that our cash and cash equivalents, short-term investments and cash generated from our customer agreements will be sufficient to meet our operating and capital requirements for at least two years. However, we may need additional financing within this time period. We may need to raise additional funds through public or private financings, licensing and contractual agreements or other arrangements. Additional funding may not be available to us on favorable terms, if at all. Furthermore, any additional equity financing would be dilutive to our shareholders, and debt financing, if available, may involve restrictive covenants. Contractual arrangements may require us to relinquish our rights to certain of our technologies, product candidates or marketing territories. If we fail to raise additional funds when needed, our business, financial condition and results of operations will be materially harmed. RISKS RELATED TO OUR INTELLECTUAL PROPERTY OUR PATENT POSITION IS UNCERTAIN AND OUR SUCCESS DEPENDS ON OUR PROPRIETARY RIGHTS. Our success depends in part on our ability to: - obtain patents; - protect trade secrets; - operate without infringing upon the proprietary rights of others; and - prevent others from infringing on our proprietary rights. We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary rights are covered by valid and enforceable patents or are effectively maintained as trade secrets. We solely own two issued patents in the United States, one granted patent in Europe, three granted patents in Japan and have several pending patent applications in the United States and abroad relating to XenoMouse technology. Our wholly-owned subsidiary, Xenotech, owns two issued U.S. patents, one Australian patent and several pending U.S. and foreign patent applications related to methods of treatment of bone disease in cancer patients. In addition, we have four issued U.S. patents and several pending patent applications in the United States and abroad that are jointly owned with Japan Tobacco relating to antibody technology or genetic manipulation. We attempt to protect our proprietary position by filing U.S. and foreign patent applications related to our proprietary technology, inventions and improvements that are important to the development of our business. However, the patent position of biopharmaceutical companies involves complex legal and factual questions, and, therefore, enforceability cannot be predicted with certainty. Patents, if issued, may be challenged, invalidated or circumvented. Thus, any patents that we own or license from third parties may not provide any protection against competitors. Our pending patent applications, those we may file in the future, or those we may license from third parties, may not result in patents being issued. Also, patent rights may not provide us with adequate proprietary protection or competitive advantages against competitors with similar technologies. The laws of certain foreign countries do not protect our intellectual property rights to the same extent as do the laws of the United States. In addition to patents, we rely on trade secrets and proprietary know-how. We seek protection, in part, through confidentiality and proprietary information agreements. These agreements may not provide meaningful protection or adequate remedies for our technology in the event of unauthorized use or disclosure of confidential and proprietary information, and, in addition, the parties may breach such agreements. Also, our trade secrets may otherwise become known to, or be independently developed by, our competitors. Furthermore, others may independently develop similar technologies or duplicate any technology that we have developed. WE MAY FACE CHALLENGES FROM THIRD PARTIES REGARDING THE VALIDITY OF OUR PATENTS AND PROPRIETARY RIGHTS. Research has been conducted for many years in the antibody field. This has resulted in a substantial number of issued patents and an even larger number of pending patent applications. Patent applications in the United States are, in most cases, maintained in secrecy until patents are issued. The publication of discoveries in the scientific or patent literature frequently occurs substantially later than the date on which the underlying discoveries were made. Our commercial success depends significantly on our ability to operate without infringing the patents and other proprietary rights of third parties. Our technologies may unintentionally infringe the patents or violate other proprietary rights of third parties. In the event of such infringement or violation, we and our customers may be prevented from pursuing product development or commercialization. Such a result will materially harm our business, financial condition and results of operations. In March 1997, we entered into a cross-license and settlement agreement with GenPharm International Inc. to avoid protracted litigation. Under the cross-license, we licensed on a non-exclusive basis certain patents, patent applications, third-party licenses and inventions pertaining to the development and use of certain transgenic rodents, including mice, that produce fully human antibodies that are integral to our products and business. Our business, financial condition and results of operations will be materially harmed if any of the parties breaches the cross-license agreement. We have one granted European patent relating to XenoMouse technology that is currently undergoing opposition proceedings within the European Patent Office and the outcome of this opposition is uncertain. Glaxo Wellcome Inc. has a family of patents which it is asserting against Genentech in ongoing litigation. If any of the claims of these patents are finally determined in the litigation to be valid and if they can be asserted by Glaxo to be infringed by ABX-EGF, then we may need to obtain a license should one be available. Should a license be denied or unavailable on commercially reasonable terms, our commercialization of ABX-EGF could be impeded in any territories in which these patents were in force. Genentech owns a U.S. patent that relates to inhibiting the growth of tumor cells involving an anti-EGF receptor antibody in combination with a cytotoxic factor. If the claims of the patent are valid, we may be required to obtain a license to Genentech's patent to label and sell ABX-EGF for some or all such combination indications. Should a license be denied or unavailable on commercially reasonable terms, our commercialization of ABX-EGF could be impeded in the United States. ImClone Systems, Inc. has announced that the United States Patent and Trademark Office has issued a notice of allowability of a patent covering a composition of matter of any EGFr monoclonal antibody that inhibits the binding of EGF to its receptor in combination with any anti-neoplastic agent, as well as the therapeutic use of such combinations. In addition, other third parties have or may receive other patents relating to EGFr monoclonal antibodies, their manufacture or their use. The scope and validity of any such patent may materially impede our planned activities. The biotechnology and pharmaceutical industries have been characterized by extensive litigation regarding patents and other intellectual property rights. The defense and prosecution of intellectual property suits, United States Patent and Trademark Office interference proceedings and related legal and administrative proceedings in the United States and internationally involve complex legal and factual questions. As a result, such proceedings are costly and time-consuming to pursue and their outcome is uncertain. Litigation may be necessary to: - enforce patents that we own or license; - protect trade secrets or know-how that we own or license; or - determine the enforceability, scope and validity of the proprietary rights of others. If we become involved in any litigation, interference or other administrative proceedings, we will incur substantial expense and the efforts of our technical and management personnel will be significantly diverted. An adverse determination may subject us to loss of our proprietary position or to significant liabilities, or require us to seek licenses that may not be available from third parties. We may be restricted or prevented from manufacturing and selling our products, if any, in the event of an adverse determination in a judicial or administrative proceeding or if we fail to obtain necessary licenses. Costs associated with these arrangements may be substantial and may include ongoing royalties. Furthermore, we may not be able to obtain the necessary licenses on satisfactory terms, if at all. These outcomes will materially harm our business, financial condition and results of operations. RISKS RELATED TO OUR INDUSTRY WE FACE INTENSE COMPETITION AND RAPID TECHNOLOGICAL CHANGE. The biotechnology and pharmaceutical industries are highly competitive and subject to significant and rapid technological change. We are aware of several pharmaceutical and biotechnology companies that are actively engaged in research and development in areas related to antibody therapy. These companies have commenced clinical trials of antibody products or have successfully commercialized antibody products. Many of these companies are addressing the same diseases and disease indications as us or our customers. Also, we compete with companies that offer antibody generation services to companies that have antigens. These competitors have specific expertise or technology related to antibody development. These companies include GenPharm International, Inc., a wholly-owned subsidiary of Medarex, Inc., Medarex's joint venture partner, Kirin Brewing Co., Ltd., Cambridge Antibody Technology Group plc, Protein Design Labs, Inc. and MorphoSys AG. Some of our competitors have received regulatory approval or are developing or testing product candidates that may compete directly with our product candidates. For example, SangStat Medical Corp. and Protein Design Labs market organ transplant rejection products that may compete with ABX-CBL, which is in clinical trials. In addition, MedImmune, Inc. has a potential antibody product candidate in clinical trials for graft versus host disease that may compete with ABX-CBL. We are also aware that several companies, including Genentech, Inc., have potential product candidates that may compete with ABX-IL8, which is in clinical trials. Furthermore, we are aware that ImClone Systems, Inc., Medarex, AstraZeneca and OSI Pharmaceuticals, Inc., have potential antibody and small molecule product candidates in clinical development that may compete with ABX-EGF, which is also in clinical trials. Many of these companies and institutions, either alone or together with their customers, have substantially greater financial resources and larger research and development staffs than we do. In addition, many of these competitors, either alone or together with their customers, have significantly greater experience than we do in: - developing products; - undertaking pre-clinical testing and human clinical trials; and - obtaining FDA and other regulatory approvals of products. Accordingly, our competitors may succeed in obtaining patent protection, receiving FDA approval or commercializing products before us. If we commence commercial product sales, we will be competing against companies with greater marketing and manufacturing capabilities, areas in which we have limited or no experience. We also face, and will continue to face, competition from academic institutions, government agencies and research institutions. There are numerous competitors working on products to treat each of the diseases for which we are seeking to develop therapeutic products. In addition, any product candidate that we successfully develop may compete with existing therapies that have long histories of safe and effective use. Competition may also arise from: - other drug development technologies and methods of preventing or reducing the incidence of disease; - new small molecules; or - other classes of therapeutic agents. Developments by competitors may render our product candidates or technologies obsolete or non-competitive. We face and will continue to face intense competition from other companies for agreements with pharmaceutical and biotechnology companies for establishing relationships with academic and research institutions, and for licenses to proprietary technology. These competitors, either alone or with their customers, may succeed in developing technologies or products that are more effective than ours. WE FACE UNCERTAINTY OVER REIMBURSEMENT AND HEALTHCARE REFORM. In both domestic and foreign markets, sales of our product candidates will depend in part upon the availability of reimbursement from third-party payors. Such third-party payors include government health administration authorities, managed care providers, private health insurers and other organizations. These third-party payors are increasingly challenging the price and examining the cost effectiveness of medical products and services. In addition, significant uncertainty exists as to the reimbursement status of newly approved healthcare products. We may need to conduct post-marketing studies in order to demonstrate the cost-effectiveness of our products. Such studies may require us to provide a significant amount of resources. Our product candidates may not be considered cost-effective. Adequate third-party reimbursement may not be available to enable us to maintain price levels sufficient to realize an appropriate return on our investment in product development. Domestic and foreign governments continue to propose and pass legislation designed to reduce the cost of healthcare. Accordingly, legislation and regulations affecting the pricing of pharmaceuticals may change before our proposed products are approved for marketing. Adoption of such legislation could further limit reimbursement for pharmaceuticals. If the government and third-party payors fail to provide adequate coverage and reimbursement rates for our product candidates, the market acceptance of our products may be adversely affected. If our products do not receive market acceptance, our business, financial condition and results of operations will be materially harmed. OTHER RISKS RELATED TO OUR COMPANY WE ACQUIRED IMMGENICS PHARMACEUTICALS INC., A VANCOUVER-BASED BIOTECHNOLOGY COMPANY IN NOVEMBER 2000. WE MAY EXPERIENCE DIFFICULTY IN THE INTEGRATION OF THIS ACQUISITION, OR ANY FUTURE ACQUISITION, WITH THE OPERATIONS OF OUR BUSINESS. In early November, we acquired all of the voting stock of ImmGenics Pharmaceuticals Inc., a Canadian biotechnology company that develops and intends to commercialize antibody-based therapeutic and diagnostic products for the treatment and diagnosis of a variety of diseases, for an aggregate consideration of approximately $77.5 million payable in a special class of ImmGenics non- voting shares that may be exchanged into our common stock. We have a limited history of operating the business of our company and ImmGenics on a consolidated basis, and we have no experience operating a business outside of the United States. We may have difficulty integrating ImmGenics' research and development operations with our own. Difficulty managing the integration of ImmGenics could result from many factors, some of which are beyond our control, including the following: - the geographic distance between our Fremont, California headquarters and our acquired Vancouver, British Columbia office; - potential differences in research and development protocols between ImmGenics and ourselves; and - the potential loss of personnel from our acquired operations. In the future, we may from time to time seek to expand our business through additional corporate acquisitions. Our acquisition of companies and businesses and expansion of operations, including the recent acquisition of ImmGenics, involve risks such as the following: - the potential inability to identify target companies best suited to our business plan; - the potential inability to successfully integrate acquired operations and businesses and to realize anticipated synergies, economies of scale or other expected value; - incurrence of expenses attendant to transactions that may or may not be consummated; and - difficulties in managing and coordinating operations at multiple venues, which, among other things, could divert our management's attention from other important business matters. In addition, our acquisition of companies and businesses and expansion of operations, including the recent acquisition of ImmGenics, may result in dilutive issuances of equity securities, the incurrence of additional debt, large one-time write-offs and the creation of goodwill or other intangible assets that could result in amortization expense. WE DEPEND ON KEY PERSONNEL AND MUST CONTINUE TO ATTRACT AND RETAIN KEY EMPLOYEES AND CONSULTANTS. We are highly dependent on the principal members of our scientific and management staff. For us to pursue product development, marketing and commercialization plans, we will need to hire additional qualified scientific personnel to perform research and development. We will also need to hire personnel with expertise in clinical testing, government regulation, manufacturing, marketing and finance. Attracting and retaining qualified personnel will be critical to our success. We may not be able to attract and retain personnel on acceptable terms given the competition for such personnel among biotechnology, pharmaceutical and healthcare companies, universities and non-profit research institutions. If we lose any of these persons, or are unable to attract and retain qualified personnel, our business, financial condition and results of operations may be materially harmed. In addition, we rely on members of our Scientific Advisory Board and other consultants to assist us in formulating our research and development strategy. All of our consultants and the members of our Scientific Advisory Board are employed by other entities. They may have commitments to, or advisory or consulting agreements with, other entities that may limit their availability to us. If we lose the services of these advisors, the achievement of our development objectives may be impeded. Such impediments may materially harm our business, financial condition and results of operations. WE HAVE IMPLEMENTED A STOCKHOLDER RIGHTS PLAN AND ARE SUBJECT TO OTHER ANTI-TAKEOVER PROVISIONS. In June 1999, our board of directors adopted a stockholder rights plan, which was amended in November 1999. The stockholder rights plan provides for a dividend distribution of one preferred share purchase right on each outstanding share of our common stock. Each right entitles stockholders to buy 1/1000th of a share of our Series A participating preferred stock at an exercise price of $120.00. Each right will become exercisable following the tenth day after a person or group, other than Cell Genesys or its affiliates, successors or assigns, announces an acquisition of 15% or more of our common stock, or announces commencement of a tender offer, the consummation of which would result in ownership by the person or group of 15% or more of our common stock. In the case of Cell Genesys, or its affiliates, successors or assigns, which beneficially owned 11.89% of our outstanding common stock as of September 30, 2000, each right will become exercisable following the tenth day after it announces the acquisition of more than 25% of our common stock, or announces commencement of a tender offer, the consummation of which would result in ownership by Cell Genesys, or its affiliates, successors or assigns, of more than 25% of our common stock. We will be entitled to redeem the rights at $0.01 per right at any time on or before the close of business on the tenth day following acquisition by a person or group of 15% or more, or in the case of Cell Genesys, or its affiliates, successors or assigns, more than 25%, of our common stock. The stockholder rights plan and certain provisions of our amended and restated certificate of incorporation and amended and restated bylaws may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. This could limit the price that certain investors might be willing to pay in the future for our common stock. Certain provisions of our amended and restated certificate of incorporation and amended and restated bylaws allow us to: - issue preferred stock without any vote or further action by the stockholders; - eliminate the right of stockholders to act by written consent without a meeting; - specify procedures for director nominations by stockholders and submission of other proposals for consideration at stockholder meetings; and - eliminate cumulative voting in the election of directors. We are subject to certain provisions of Delaware law which could also delay or make more difficult a merger, tender offer or proxy contest involving us. In particular, Section 203 of the Delaware General Corporation Law prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met. The stockholder rights plan, the possible issuance of preferred stock, the procedures required for director nominations and stockholder proposals and Delaware law could have the effect of delaying, deferring or preventing a change in control of us, including, without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock. The provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. WE FACE PRODUCT LIABILITY RISKS AND MAY NOT BE ABLE TO OBTAIN ADEQUATE INSURANCE. The use of any of our product candidates in clinical trials, and the sale of any approved products, may expose us to liability claims resulting from such use or sale of our products. These claims might be made directly by consumers, healthcare providers or by pharmaceutical companies or others selling such products. We may experience financial losses in the future due to product liability claims. We have obtained limited product liability insurance coverage for our clinical trials, and insurance coverage limits are $5.0 million per occurrence and $5.0 million in the aggregate. We intend to expand our insurance coverage to include the sale of commercial products if marketing approval is obtained for product candidates in development. We may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts to protect us against losses. If a successful product liability claim or series of claims is brought against us for uninsured liabilities or in excess of insured liabilities, our business, financial condition and results of operations may be materially harmed. OUR OPERATIONS INVOLVE HAZARDOUS MATERIALS. Our research and manufacturing activities involve the controlled use of hazardous materials. We cannot eliminate the risk of accidental contamination or injury from these materials. In the event of an accident or environmental discharge, we may be held liable for any resulting damages, which may exceed our financial resources and may materially harm our business, financial condition and results of operations. WE DO NOT INTEND TO PAY CASH DIVIDENDS ON OUR COMMON STOCK. We intend to retain any future earnings to finance the growth and development of our business and we do not plan to pay cash dividends on our common stock in the foreseeable future. OUR STOCK PRICE IS HIGHLY VOLATILE. The market price and trading volume of our common stock are volatile, and we expect such volatility to continue for the foreseeable future. For example, during the period between September 30, 1999 and September 30, 2000, our common stock closed as high as $99.75 per share and as low as $9.32 per share. This may impact your decision to buy or sell our common stock. Factors affecting our stock price include: - fluctuations in our operating results; - announcements of technological innovations or new commercial therapeutic products by us or our competitors; - published reports by securities analysts; - progress with clinical trials; - government regulation; - changes in reimbursement policies; - developments in patent or other proprietary rights; - developments in our relationship with customers; - public concern as to the safety and efficacy of our products; and - general market conditions.

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+RISK FACTORS Investing in the shares of our common stock offered by this prospectus involves a high degree of risk. You should carefully consider the risks described below in addition to the other information in this prospectus. Our business, operating results and financial condition could be seriously harmed due to any of the following risks. The trading price of the shares of our common stock could decline due to any of these risks, and you could lose all or part of your investment. RISKS RELATED TO OUR BUSINESS WE HAVE A HISTORY OF LOSSES AND WE COULD SUFFER LOSSES IN THE FUTURE. Until the second half of 1997, we incurred substantial losses. Our losses were $1.6 million for 1997 and $15.3 million for 1996. As of December 31, 1999, we had an accumulated deficit of $18.9 million. Although we have operated profitability since the third quarter of 1997, we cannot assure you that we will sustain profitability on a quarterly or annual basis in the future. We expect to continue to incur increasing cost of revenues, research and development, sales and marketing and general and administrative expenses. If we are to continue to sustain profitability given our planned expenditure levels, we will need to generate and sustain increased revenues. OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE CAUSING VOLATILITY, OR DECLINE IN THE MARKET PRICE OF OUR COMMON STOCK. Our revenues, gross margins and other operating results have fluctuated significantly in the past and may vary significantly from quarter to quarter. These fluctuations may be due to a number of factors, many of which are beyond our control. These factors include: - the relatively long sales cycles for our products, - the size and timing of our licensing transactions, - the timing of release, proper operation and market acceptance of our rejuvenated products, product enhancements or new products, - changes in the budget cycles of our customers, - seasonality of our customers' technology purchases, and - foreign currency exchange rates. The timing of our revenue recognition can be affected by many factors, including the timing of a contract's execution and delivery, a customer's acceptance and our post-delivery obligations with respect to the installation and implementation of our products. As a result, the time between contract execution and the satisfaction of the criteria necessary for revenue recognition can be lengthy and unpredictable and, consequently, may affect our revenues. As a result, it is possible that in some future quarters our results of operations may fall below the expectations of some securities analysts and investors. In that event, the trading price of our stock may likely be materially and adversely affected. WE MAY ACQUIRE OTHER COMPANIES' PRODUCTS, TECHNOLOGIES OR BUSINESSES THAT COULD BE DIFFICULT TO INTEGRATE, DISRUPT OUR BUSINESS AND DILUTE STOCKHOLDER VALUE. As part of our strategy, we expect to continue to pursue acquisitions of other businesses, products and technologies. In connection with an acquisition, we may pay cash, issue stock or incur debt. Our stockholders will be diluted if we finance acquisitions by incurring convertible debt or issuing equity securities. In addition, we may be required to incur expenses related to goodwill and other intangible asset amortization. Acquisitions of companies and businesses also involve numerous other risks, including: - difficulties in the assimilation of the operations, technologies, products and personnel of the acquired business, - diversion of our management's attention from other business concerns, - risks of entering markets in which we have no or limited direct experience, and - the potential loss of key employees of the acquired business. From 1993 through 1996, we acquired eleven companies with aggregate annual revenues in the last fiscal year prior to acquisition of approximately $24.2 million and we recently acquired e-nnovations.com which had revenues of approximately $3.1 million in 1999. Our acquisition strategy is focused on acquisitions that are potentially larger in scope and size than any of our previous acquisitions and we cannot assure you that we will successfully integrate an acquisition of this size into our operations. Although we currently have no agreement, understanding or arrangement with respect to any future acquisitions, we continually evaluate acquisition opportunities. Any future acquisition may also disrupt our ongoing business, divert the attention of our management and employees from day to day operations and increase our operating expenses. FAILURE TO MANAGE OUR GROWTH MAY SERIOUSLY HARM OUR ABILITY TO DELIVER PRODUCTS IN A TIMELY MANNER, FULFILL EXISTING CUSTOMER COMMITMENTS AND ATTRACT AND RETAIN NEW CUSTOMERS. We have grown rapidly in the last five years, with total revenues increasing from $21.4 million in 1995 to $73.4 million in 1999. Our growth has placed a significant strain on our management, operations and financial resources. Our recent expansion has resulted in substantial growth in the number of our employees, the scope of our operating and financial reporting systems and the geographic area of our operations. This growth has placed, and will continue to place, a significant strain on our managerial, operational and financial resources. Accordingly, our future operating results will depend on our ability to continue to implement and improve our operational and customer support systems and to expand, train and manage our employee base. We cannot assure you that we will be able to manage our expansion successfully, and our inability to do so may seriously harm our ability to deliver products in a timely manner, fulfill existing customer commitments and attract and retain new customers. WE MUST SUCCESSFULLY DEVELOP NEW PRODUCTS AND KEEP PACE WITH RAPID TECHNOLOGICAL CHANGE TO REMAIN COMPETITIVE. The market for our products is characterized by rapid technological changes, evolving industry standards in computer hardware and software technology, changes in customer requirements and frequent new product introductions and enhancements. Our future success will depend upon our ability to continue to enhance our current product line and to develop and introduce new products that keep pace with technological developments, satisfy increasingly sophisticated customer requirements and achieve market acceptance. We cannot assure you that we will be successful in developing and marketing, on a timely and cost-effective basis, fully functional product enhancements or new products that respond to technological advances by others. We can also not assure you that our new or enhanced products will achieve market acceptance. Our customers utilize a wide variety of hardware, software, database and networking platforms. As a result, we must continue to support and maintain our products on a variety of these platforms. In particular, we must continue to anticipate and respond adequately to advances in other software and desktop computer operating systems like Microsoft Windows. WE MAY NOT SUCCEED IN PENETRATING THE E-BUSINESS AND APPLICATION SERVICE PROVIDER MARKETS. We may not have the resources, skills and product offerings that will be required to successfully penetrate the e-business and application service provider markets. To succeed in these markets, we must continue to: - develop expertise in marketing and selling Internet-based applications and services, - develop and cultivate new sales channels to market our applications to prospective customers, and - hire, train and integrate new technical and sales personnel. The e-business and application service provider markets that we may attempt to penetrate may not become substantial commercial markets for our applications or may not evolve in a manner that will enable our applications to achieve broad market acceptance. UNDETECTED ERRORS MAY INCREASE OUR COSTS AND IMPAIR THE MARKET ACCEPTANCE OF OUR PRODUCTS AND TECHNOLOGY. Our products and technology have occasionally contained, and may in the future contain, undetected errors when first introduced or when new versions are released. Our customers integrate our products and technology into systems and products that they develop themselves or acquire from other vendors. As a result, when problems occur in equipment or a system into which our products or technology have been incorporated, it may be difficult to identify their cause. Regardless of the source of these errors, we must divert the attention of our engineering personnel from our research and development efforts to address the errors. We cannot assure you that we will not incur warranty or repair costs, be subject to liability claims for damages related to product errors or experience delays as a result of these errors in the future. Any insurance policies that we have may not provide sufficient protection should a claim be asserted. Moreover, the occurrence of errors, whether caused by our products or technology or the products of another vendor, may result in significant customer relations problems and injury to our reputation and may impair the market acceptance of our products and technology. WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS FROM PRODUCT DEFECTS, WHICH MAY HARM OUR OPERATING RESULTS. If our products malfunction or suffer from design defects, we may also be subject to product liability claims. Our license agreements with our customers typically contain provisions designed to limit our exposure to liabilities arising from product liability claims. We also maintain errors and omissions liability insurance in the amount of $6.0 million for damages as a result of product defects or errors. However, we cannot assure you that the provisions in our license agreements limiting our liability will be enforceable under international, federal, state or local laws and judicial decisions or that our insurance coverage will be sufficient to cover all losses resulting from product defects or errors. To the extent our insurance is insufficient to cover any losses we may incur, our operating results will suffer. COMPETITION IN THE MARKETS FOR OUR PRODUCTS AND TECHNOLOGY IS INTENSE. WE MAY NOT BE ABLE TO COMPETE EFFECTIVELY IN THESE MARKETS AND WE MAY LOSE MARKET SHARE TO OUR COMPETITORS. The markets for our enterprise-wide software applications are intensely competitive and we expect competition to intensify in the future. We may not be able to compete effectively in these markets and we may lose market share to our competitors. Our principal competitors for products sold to customers in the manufacturing industry include Epicor, Fourth Shift, QAD and Symix. We also believe that large enterprise software vendors, like Baan, Oracle, PeopleSoft and SAP, are increasing their marketing efforts to mid-sized organizations in the manufacturing industry. In the healthcare industry, our principal competitors include EMIS, GPASS, In Practice and TOREX. In the hospitality industry, our principal competitors are Innsite and MICROS Systems. In the construction industry, our competitors include Database, Estimation and FCG Computer Systems. In addition, we face indirect competition from suppliers of customized enterprise-wide software applications with highly customized software and from the internal information technology departments of large organizations who develop their own systems. MANY OF OUR COMPETITORS HAVE GREATER RESOURCES THAN WE DO. THIS MAY LIMIT OUR ABILITY TO COMPETE EFFECTIVELY AND MAY DISCOURAGE CUSTOMERS FROM PURCHASING OUR PRODUCTS. Many of our competitors have greater financial, personnel and other resources than we do, which may limit our ability to compete effectively. These competitors may be able to respond more quickly to new or emerging technologies or changes in customer requirements. These competitors may also: - benefit from greater economies of scale, - benefit from longer operating histories and name recognition, - offer more aggressive pricing, and - devote greater resources to the promotion of their products. Any of these advantages may discourage customers from purchasing our products. If we are unable to compete successfully against our existing or potential competitors, our revenues and margins will decline. WE FACE A RISK FROM INCREASED COMPETITION AS A RESULT OF ACQUISITIONS OF COMPETITORS BY LARGE SOFTWARE COMPANIES. We believe the fragmented nature of the enterprise-wide software applications market will result in future acquisitions of competitors by large software companies or strategic alliances, which will lead to significant consolidation in our industry. As a result, we may face an increase in competition from larger companies and new entrants to the industry which could harm our business and cause our stock price to decline. OUR ABILITY TO ACQUIRE COMPLEMENTARY BUSINESSES AND PRODUCTS MAY BE HARMED BY THE INCREASING CONSOLIDATION IN OUR MARKETS. Increasing consolidation in our markets may require us to compete with other software companies for strategic acquisition opportunities. We have acquired complementary businesses and products in the past and we expect to continue to pursue similar opportunities in the future. As competition in our markets has increased, a number of our competitors have been acquired or have entered into strategic alliances. A continuation of this trend may require us to compete with other software companies for attractive acquisition opportunities and may lead to fewer opportunities and increased acquisition costs which will harm our acquisition strategy. OUR LENGTHY SALES AND IMPLEMENTATION CYCLES MAY CAUSE FLUCTUATIONS IN OUR OPERATING RESULTS, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE. Sales of our products require an extensive marketing effort because decisions to purchase these products generally involve the evaluation of the product by a significant number of a potential customer's personnel in various functional and geographic areas. Our products are generally used for division- or enterprise-wide purposes and involve significant capital outlays by customers and relatively complex installations. Potential customers generally commit significant resources to evaluate available enterprise-wide software applications and require us to provide a significant level of education about the use and benefits of our products. As a result, our sales cycle averages between one and 12 months from initial contact to execution of a license agreement. Our ability to forecast the timing and amount of specific sales is limited, and the delay or failure to complete one or more large license transactions could cause our operating results to fall below the expectations of securities analysts and investors and cause our stock price to decline. WE ARE DEPENDENT ON OUR KEY PERSONNEL, PARTICULARLY DR. LYCOURGOS K. KYPRIANOU, OUR FOUNDER AND CHIEF EXECUTIVE OFFICER. ANY LOSS OF THE SERVICES OF OUR KEY PERSONNEL WOULD HARM OUR BUSINESS. Our future success depends to a large extent on the continued services of our senior management and key personnel. In particular, we are highly dependent on the services of Dr. Lycourgos K. Kyprianou, our founder and chief executive officer. If we were to lose the services of Dr. Kyprianou or other key personnel, our ability to manage operations and generate revenues would be harmed. OUR FAILURE TO RETAIN AND ATTRACT QUALIFIED PERSONNEL COULD HARM OUR BUSINESS. Our products require sophisticated research and development, sales and marketing, and technical customer support. Our success depends on our ability to attract, train and retain qualified personnel in each of these areas. Competition for personnel in all of these areas is intense and we may not be able to hire sufficient personnel to achieve our goals or support the anticipated growth in our business. The market for the highly-trained personnel we require is very competitive, due to the limited number of people available with the necessary technical skills and understanding of our products and technology. If we fail to attract and retain qualified personnel, our business will suffer. OUR LIMITED ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS MAY HARM OUR COMPETITIVENESS. Our success is substantially dependent upon the protection of our internally developed technology, including our Aremis architecture. Our profitability could suffer if third parties infringe upon our intellectual property rights or misappropriate our technology and other assets. To protect our rights to our intellectual property, we rely on the protection provided by applicable copyright, trademark and trade secret laws, confidentiality procedures and licensing arrangements to establish and protect our proprietary rights. We have a trademark application pending, but do not currently hold any patents or registered copyrights. Despite our efforts, it may be possible for unauthorized third parties to copy portions of our products or reverse engineer or obtain and use information that we regard as proprietary. Policing unauthorized use of our software is difficult and, while we are unable to determine the extent to which piracy of our products exists, software piracy can be expected to be a problem. In addition, the laws of some countries, including India and the United Kingdom, do not protect our proprietary rights to the same extent as do the laws of the United States. Any failure by us to protect our intellectual property could result in competitors offering products incorporating the same or similar technology which could reduce demand for our products. Further, litigation to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others could result in substantial costs and diversion of resources. OUR PRODUCTS MAY INFRINGE ON THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, WHICH COULD INCREASE OUR COSTS AND NEGATIVELY AFFECT OUR PROFITABILITY. We expect that enterprise-wide software applications will increasingly be subject to claims of infringement relating to software codes as the number of products and competitors in our industry segment grows and the functionality of products overlaps. We do not currently have liability insurance to protect against the risk of third party intellectual property infringement claims. Any claim, with or without merit and whether or not insured against, could be time-consuming, result in costly litigation and require us to enter into royalty and licensing agreements. These royalty or licensing agreements, if required, might not be available on terms that are acceptable to us. An infringement claim, even if not meritorious, could result in the expenditure of significant resources and could negatively affect our profitability. WE OCCASIONALLY ENTER INTO FIXED PRICE SERVICE CONTRACTS, WHICH MAY LEAD TO LOWER MARGINS AND HARM OUR OPERATING RESULTS. We offer a combination of enterprise-wide software applications, implementation and support services to our customers. We have, from time to time, entered into fixed-price service contracts that require us to provide support services for a fixed price regardless of our actual costs incurred in fulfilling our support service obligations. Revenues attributable to fixed-price service contracts were approximately 11% of our total revenues for 1997, approximately 11% of our total revenues for 1998 and approximately 14% of our total revenues for 1999. Our inability to successfully complete these contracts, as budgeted, could lead to lower operating margins and reduced revenues and profits. RISKS RELATED TO OUR INTERNATIONAL OPERATIONS OUR RESULTS OF OPERATIONS MAY BE ADVERSELY IMPACTED BY CURRENCY FLUCTUATIONS. We currently have operations in Argentina, Bulgaria, Germany, India, Ireland, Mexico, the United Kingdom and the United States and independent distributors in 14 additional countries. A significant portion of our revenues is received in currencies other than the United States dollar, primarily in the British pound. We also anticipate receiving substantial future payments in Bulgarian Leva relating to our work with the Bulgarian National Health Insurance Fund and other customers in Bulgaria. Because our financial statements are reported in United States dollars, fluctuations of the British pound and other currencies against the United States dollar have caused, and will continue to cause, us to recognize foreign currency transaction gains or losses, which may be material to our operations and impact our reported financial condition and results of operations. WE FACE RISKS ASSOCIATED WITH DOING BUSINESS IN INTERNATIONAL MARKETS. Our principal executive offices are located in the United Kingdom. Revenues from our operations outside of the United States accounted for approximately 97% of our total revenues in 1999. We expect that a significant portion of revenues for the foreseeable future will be derived outside the United States. We are subject to risks inherent in international business activities, including: - difficulties in collecting accounts receivable and longer collection periods, - changing and conflicting regulatory requirements, - potentially adverse tax consequences, - tariffs and general export restrictions, - difficulties in staffing and managing foreign operations, - political instability, - reduced protection for intellectual property rights in some countries, and - fluctuations in currency exchange rates. THE TAX BENEFITS THAT WE CURRENTLY RECEIVE IN INDIA MAY BE LOST IF WE FAIL TO SATISFY SPECIFIED CONDITIONS. We maintain development and support facilities in New Delhi and Bangalore, India. As of March 14, 2000, we had approximately 40% of our workforce in India. As a means of encouraging foreign investment, the Indian government provides tax incentives and exemptions from regulatory restrictions. Among the benefits that directly affect us are tax holidays (temporary exemptions from taxation on operating income) and liberalized import and export duties. The current tax holiday to which we are entitled expires in March 2001. To be eligible for these tax benefits, we must continue to meet specified conditions including continuing to operate in a qualified software technology park and exporting sales of at least 75% of our inventory turnover. Our failure to meet these conditions could result in cancellation of the benefits or a requirement to pay damages in an amount as later determined by the Indian government and customs duty on plant, machinery, equipment, raw materials, components and consumables. In addition, goods, raw materials and components for production imported by our offices in India are generally exempt from the levy of a customs duty. These tax benefits could be discontinued or modified in the future which could significantly harm our operations in India. OUR OPERATING RESULTS MAY BE HARMED BY CHANGING CONDITIONS IN INDIA. Although wage costs in India are significantly lower than in the United States, the United Kingdom and similar markets for comparably skilled software engineering and other technical personnel, wages in India are increasing at a faster rate than in the United States and the United Kingdom. In the past, India has experienced significant inflation and shortages of foreign exchange, and has been subject to civil unrest and acts of terrorism. Although the effect of inflation on our financial statements for the periods discussed in this prospectus has been insignificant, increases in inflation in the future or changes in interest rates, taxation or other social, political, economic or diplomatic developments could harm our operating results. OUR PRODUCTS FOR THE HEALTHCARE INDUSTRY ARE SUBJECT TO GOVERNMENT REGULATIONS AND SPECIFICATIONS THAT CAN BE DIFFICULT TO SATISFY. OUR EFFORTS TO SATISFY THESE REGULATIONS AND SPECIFICATIONS MAY CAUSE THE PRICES OF OUR PRODUCTS TO INCREASE SUBSTANTIALLY, WHICH MAY ADVERSELY AFFECT SALES. Our products designed for the healthcare industry in the United Kingdom are regulated by the National Health Service, a governmental agency commonly referred to as the NHS, through a product accreditation procedure. While our healthcare products currently meet NHS specifications for information systems, these requirements are expected to be updated pursuant to the NHS' new Information Management and Technology Strategy. The new mandatory specifications are expected to require that all information technology systems in the United Kingdom's healthcare marketplace conform with one another. Although we are currently modifying our healthcare industry products in anticipation of the proposed specifications, we may not meet all of these specifications or, if we meet them, our related costs may be substantial and make the cost of our healthcare products prohibitive for our customers. In addition, we have experienced and expect to continue to experience a decrease in purchases of our existing healthcare products as organizations in the healthcare industry in the United Kingdom postpone purchases pending release of final regulations and specifications. These regulations and specifications, as well as future changes to NHS specifications for information systems, could harm our revenues from healthcare related products. IT MAY BE DIFFICULT TO ENFORCE A U.S. JUDGMENT AGAINST US, OUR OFFICERS AND DIRECTORS AND SOME OF THE EXPERTS NAMED IN THIS PROSPECTUS, OR TO ASSERT U.S. SECURITIES LAWS CLAIMS IN THE UNITED KINGDOM AND TO SERVE PROCESS ON SUBSTANTIALLY ALL OF OUR OFFICERS AND DIRECTORS AND THESE EXPERTS. A majority of our directors, all of our executive officers and some of the experts named in this prospectus are nonresidents of the United States. A substantial portion of our assets and all or a substantial portion of the assets of these officers and experts are located outside of the United States. As a result, it may be difficult to effect service of process within the United States with respect to matters arising under the United States securities laws or to enforce, in United States courts, judgments predicated upon civil liability under U.S. securities laws. It also may be difficult to enforce in the United Kingdom, in original actions or in actions for enforcement of judgments of U.S. courts, civil liabilities predicated upon U.S. securities laws. RISKS RELATED TO THIS OFFERING DR. KYPRIANOU OWNS A LARGE PERCENTAGE OF OUR VOTING STOCK AND HAS SIGNIFICANT INFLUENCE OVER MATTERS REQUIRING SHAREHOLDER APPROVAL, WHICH COULD DELAY OR PREVENT A CHANGE OF CONTROL. Following the closing of this offering, Dr. Kyprianou will beneficially own approximately 42% of the outstanding common stock. In connection with the private placement with Info-quest, an information technology company listed on the Athens Stock Exchange, Dr. Kyprianou and Info-quest entered into a voting agreement. As a result of the voting agreement, Dr. Kyprianou's beneficial ownership includes shares held by Info-quest. The voting agreement requires Dr. Kyprianou to vote his shares to elect board representatives of Info-quest and Info-quest is similarly required to vote its shares for the board representatives nominated by our board of directors. In addition, the agreement provides that each of Dr. Kyprianou and Info-quest vote their shares by mutual agreement on all other matters. As a result, these stockholders may, as a practical matter, be able to substantially influence all matters requiring stockholder approval which could delay or prevent a change of control. OUR COMMON STOCK PRICE HAS BEEN VOLATILE IN THE PAST AND MAY BE VOLATILE IN THE FUTURE. The market price of our common stock is highly volatile and may be subject to significant fluctuations in response to actual or anticipated variations in quarterly operating results and other factors. From the time of our initial public offering through March 14, 2000, the closing price of our common stock reported on the Nasdaq National Market has ranged from $3 7/8 to $46 1/8 per share. In addition, the stock market in general, and the market for technology related stocks in particular, has experienced extreme volatility that often has been unrelated to the operating performance of particular companies. These broad market and industry fluctuations may adversely affect the trading price of our common stock, regardless of our actual operating performance. PROVISIONS OF OUR CORPORATE DOCUMENTS AND DELAWARE LAW COULD DETER TAKEOVERS WHICH MAY PREVENT YOU FROM RECEIVING A PREMIUM FOR YOUR SHARES. Provisions of our certificate of incorporation, bylaws and Delaware law could delay, defer or prevent a change in our control. Our board of directors has the authority to issue up to 15,000,000 shares of preferred stock and to fix the rights, preferences, privileges and restrictions of those shares, including voting rights, without any further vote or action by the stockholders. The rights of our common stockholders could be adversely affected by the rights of preferred stockholders in the future. In addition, we are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a "business combination" with an "interested stockholder" for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner under Delaware law. The ability of our board of directors to issue shares of preferred stock without further stockholder approval, as well as the anti-takeover provisions of Delaware law, could have the effect of delaying, deferring or preventing a change in control, even if doing so would be beneficial to our stockholders. WE DO NOT EXPECT TO PAY DIVIDENDS. We have never declared or paid any cash dividends on our common stock. We currently expect to retain our future earnings for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.

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+RISK FACTORS YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS AND ALL OTHER INFORMATION CONTAINED IN THIS PROSPECTUS BEFORE PURCHASING OUR COMMON STOCK. INVESTING IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. ANY OF THE FOLLOWING RISKS COULD MATERIALLY HARM OUR BUSINESS, RESULTS OF OPERATIONS AND FINANCIAL CONDITION AND COULD RESULT IN A COMPLETE LOSS OF YOUR INVESTMENT. RISKS PARTICULAR TO NATIONAL INFORMATION CONSORTIUM BECAUSE WE HAVE PORTAL SERVICE CONTRACTS WITH A LIMITED NUMBER OF STATES AND CITY GOVERNMENTS, THE TERMINATION OF CERTAIN OF THESE CONTRACTS MAY HARM OUR BUSINESS Currently, virtually all of our revenues are derived from the operation of our portal business. We have portal contracts with 11 states and one local government. These contracts typically have initial terms of three to five years with optional renewal periods of one to five years. However, any renewal is optional and a government may terminate its contract prior to the expiration date upon specific cause events that are not cured within a period of ten to 180 days or, in some cases, upon passing legislation. Additionally, the contracts under which we provide management and development services can be terminated without cause on a specified period of notice. The loss of one or more of our larger government portal clients, if not replaced, could dramatically reduce our revenues. If these revenue shortfalls occur, our business and financial condition would be harmed. We cannot be certain if, when or to what extent governments might fail to renew or terminate any or all of their contracts with us. WE MAY BE UNABLE TO OBTAIN FUTURE CONTRACTS THROUGH THE REQUEST FOR PROPOSAL PROCESS Much of our current revenues is derived from contracts with governments and government agencies that operate under special rules that apply to government purchasing. Where this process applies, there are special rules that typically require open bidding by possible service providers like us against a list of requirements established by governments under existing or specially-created procedures. To respond successfully to these requests for proposals, commonly known as RFPs, we must estimate accurately our cost structure for servicing a proposed contract, the time required to establish operations for the proposed client and the likely terms of any other proposals submitted. We also must assemble and submit a large volume of information within the strict time schedule mandated by an RFP. Whether or not we are able to respond successfully to RFPs in the future will significantly impact our business. We cannot guarantee that we will win any bids in the future through the RFP process, or that any winning bids will ultimately result in contracts. Even though we have broadened our product and service offerings, we still depend on the RFP process for a substantial part of our future contracts. Therefore, our business, results of operations and financial condition would be harmed if we fail to obtain profitable future contracts through the RFP process. OUR ACQUISITIONS AND STRATEGIC ALLIANCES ENTAIL NUMEROUS RISKS AND UNCERTAINTIES As part of our business strategy, we have made and will continue to make acquisitions or enter into strategic alliances that we believe will complement our existing businesses, increase traffic to our government clients' sites, enhance our services, broaden our software and applications offerings or technological capabilities or increase our revenues. On September 15, 1999, we acquired all of the assets of the eFed division of Electric Press, Inc. and thereby began offering online government procurement services to federal, state and local governments. On January 12, 2000, we strengthened our existing online systems for Secretaries of State by combining our Application Services Division with Conquest Softworks, LLC. On February 16, 2000, we signed a definitive agreement to acquire SDR Technologies, Inc., a company which develops and provides online elections and ethics filings for state and local governments. These acquisitions and future acquisitions or joint ventures could present numerous risks and uncertainties, including: - difficulties in the assimilation of operations, personnel, technologies, products and information systems of the acquired companies; - the inability to successfully market, distribute, deploy and manage new products and services that we have limited or no experience in managing; - the diversion of management's attention from our core business; - the risk that an acquired business will not perform as expected; - risks associated with entering markets in which we have limited or no experience; - potential loss of key employees, particularly those of the purchased organizations; - adverse effects on existing business relationships with existing suppliers and customers; - potentially dilutive issuances of equity securities, which may be freely tradeable in the public market; - significant charges; and - the incurrence of debt or other expenses related to goodwill and other intangible assets. We cannot assure you that any acquisitions we have announced or will announce, including our recently signed agreement with SDR Technologies, will ultimately close. Moreover, even after we close such transactions, we cannot assure you that we will be able to successfully integrate the new businesses or any other businesses, products or technologies we may acquire in the future. WE HAVE INCURRED NET LOSSES AND EXPECT TO CONTINUE TO INCUR NET LOSSES FOR THE FORESEEABLE FUTURE We incurred net losses of approximately $10.7 million for the year ended December 31, 1999 and approximately $7.9 million for the year ended December 31, 1998. We also expect to incur significant operations expenses and will need to generate increased revenues to achieve profitability. Further, even if we achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. As a result, we will need to generate significantly higher revenues while containing costs and operating expenses if we are to achieve profitability. We cannot be certain that our revenues will continue to grow or that we will ever achieve sufficient revenues to become profitable. WE MAY BE UNABLE TO SUSTAIN THE USAGE LEVELS OF CURRENT PRODUCTS AND SERVICES THAT PROVIDE A SIGNIFICANT PERCENTAGE OF OUR REVENUES We obtain a high proportion of our revenues from a limited number of products and services. Subscription-based and transaction-based fees charged for access to motor vehicle records and corporate filings accounted for over 89% of our revenues for the year ended December 31, 1999 and are expected to continue to account for a significant portion of our revenues in the near future. Regulatory changes or the development of alternative information sources could materially reduce our revenues from these products and services. A reduction in revenues from currently popular products and services would harm our business, results of operations and financial condition. IF OUR POTENTIAL CUSTOMERS ARE NOT WILLING TO SWITCH TO OR ADOPT OUR ONLINE GOVERNMENTAL PORTALS AND OTHER ELECTRONIC SERVICES, OUR GROWTH AND REVENUES WILL BE LIMITED The failure to generate a large customer base would harm our growth and revenues. This failure could occur for several reasons. Our future revenues and profits depend upon the widespread acceptance and use of the Internet as an effective medium for accessing public information, particularly as a medium for government procurement and filings. We cannot assure you that customer acceptance and use of the Internet will continue to grow. Additionally, we face intense competition in all sectors of our business. As a result, our efforts to create a larger customer base may be more difficult than expected even if we are perceived to offer products and services superior to those of our competitors. Further, because the government-to-citizen and government-to-business portal access and electronic filing market is relatively new, potential customers in this market may be confused or uncertain about the relative merits of each electronic government solution and of which solution to adopt, if any. Confusion and uncertainty in the marketplace may inhibit customers from adopting our solution, which could harm our business, results of operations and financial condition. THE FEES WE COLLECT FOR MANY OF OUR PRODUCTS AND SERVICES ARE SUBJECT TO REGULATION THAT COULD LIMIT GROWTH OF OUR REVENUES AND PROFITABILITY We collect user fees on behalf of government agencies and, under the terms of our government contracts, we remit a portion of the fees to state agencies. Generally, our contracts provide that the amount of any fees we retain is set by governments to provide us with a reasonable return or profit or, in one case, a specified return on equity. We have limited control over the level of fees we are permitted to retain. Our business, results of operations and financial condition may be harmed if the level of fees we are permitted to retain in the future is too low or if our costs rise without a commensurate increase in fees. THE POSSIBILITY OF GOVERNMENTS DEMANDING FIXED-PRICE CONTRACTS MAY SIGNIFICANTLY REDUCE OUR REVENUES AND PROFITS Substantially all of our present contracts are on a transaction-fee basis, through which our fees vary depending on the number of Internet users who access our products and services. However, we cannot assure you that governments will not demand fixed-price contracts in the future. Currently, we earn fees under our contracts with the states of Georgia and Iowa predominantly on a fixed-price basis. We may, from time to time, enter into other fixed-price contracts. Our failure to estimate accurately the resources and time required for an engagement, to manage governments' expectations effectively regarding the scope of services to be delivered for an estimated price or to complete fixed-price engagements within budget, on time and to governments' satisfaction could expose us to risks associated with cost overruns and, potentially, to penalties, which may harm our business, results of operations and financial condition. WE HAVE EXPERIENCED SIGNIFICANT GROWTH IN OUR BUSINESS IN RECENT PERIODS AND FAILURE TO MANAGE OUR GROWTH COULD STRAIN OUR MANAGEMENT AND OTHER RESOURCES Our ability to successfully offer products and services and implement our business plan in a rapidly evolving market requires an effective planning and management process. We have acquired a number of new businesses or combined with existing entities to create new businesses, including eFed and NIC Conquest, which have strained our management resources. Future expansion efforts could be expensive and put a strain on our management and other resources. We have increased, and plan to continue to increase, the scope of our operations at a rapid rate. Our headcount has grown and will continue to grow substantially. At December 31, 1998, we had a total of 95 employees, at December 31, 1999, we had a total of 185 employees, and at February 29, 2000, we had a total of 235 employees. In addition, we expect to hire a significant number of new employees in the near future. To manage future growth effectively, we must maintain and enhance our financial and accounting systems and controls, integrate new personnel and manage expanded operations. BECAUSE A MAJOR PORTION OF OUR CURRENT REVENUES IS GENERATED FROM A SMALL NUMBER OF USERS, THE LOSS OF ANY OF THESE USERS MAY HARM OUR BUSINESS AND FINANCIAL CONDITION Our revenues are primarily derived from data resellers' use of our electronic government portals to access motor vehicle records for sale to the automobile insurance industry. For the year ended December 31, 1999, one of these data resellers, ChoicePoint, accounted for approximately 67% of our revenues. Two other resellers accounted for an additional 11% of our revenues during the year ended December 31, 1999. It is possible that these users will develop alternative data sources or new business processes that would materially diminish their use of our portals. The loss of all or a substantial portion of business from any of these entities would harm our business and financial condition. WE MAY LOSE THE RIGHT TO THE CONTENT DISTRIBUTED THROUGH OUR GOVERNMENT PORTALS, WHICH IS PROVIDED TO US ENTIRELY BY GOVERNMENT ENTITIES We do not own or create the content distributed through our government portals. We depend on the governments with which we contract to supply information and data feeds to us on a timely basis to allow businesses and citizens to complete transactions and obtain government information. We cannot assure you that these data sources will continue to be available in the future. Government entities could terminate their contracts to provide data. Changes in regulations could mean that governments no longer collect some types of data or that the data is protected by more stringent privacy rules preventing uses now made of it. Moreover, our data sources are not always subject to exclusive agreements, so that data included in our products and services also may be included in those of our potential competitors. In addition, we are dependent upon the accuracy and reliability of government computer systems and data collection for the content of our portals. The loss or the unavailability of our data sources in the future, or the loss of our exclusive right to distribute some of the data sources, could harm our business, results of operations and financial condition. THE GROWTH IN OUR REVENUES MAY BE LIMITED BY THE NUMBER OF STATES THAT CHOOSE TO PROVIDE ELECTRONIC GOVERNMENT SERVICES AND TO ADOPT OUR BUSINESS MODEL AND BY THE FINITE NUMBER OF STATES WITH WHICH WE MAY CONTRACT FOR OUR ELECTRONIC GOVERNMENT SERVICES Although we have recently introduced new products and services through our recently acquired subsidiary, eFed, our revenues are generated principally from contracts with state governments to provide electronic government services on behalf of those governments to complete transactions and distribute public information electronically. The growth in our revenues largely depends on government entities adopting our public/private model and our ability to enter into contracts with those entities. We cannot assure you that government entities will choose to provide electronic government services at all, that they will not provide such services themselves without private assistance or adopting our public/ private model, or that we will be selected as the service provider if the model is adopted. For example, recently the state of Texas considered our proposal for a public/private portal that involved a more limited number of revenue-based applications and services than our other state portals. We were subsequently informed that the state of Texas did not select our proposal and is currently negotiating with another vendor. In addition, as there is a finite number of states remaining with which we can contract for our services, future increases in our revenues will depend on our ability to expand our business model to include multi-state cooperative organizations, local governments, federal agencies and international entities. We cannot assure you that we will succeed in our expansion into new markets or that our services will be adaptable to those new markets. OUR BUSINESS WITH VARIOUS GOVERNMENT ENTITIES OFTEN REQUIRES SPECIFIC GOVERNMENT LEGISLATION TO BE PASSED FOR US TO INITIATE AND MAINTAIN OUR GOVERNMENT CONTRACTS Because a central part of our business includes the execution of contracts with governments under which we remit a portion of user fees charged to businesses and citizens to state agencies, it is often necessary for governments to draft and adopt specific legislation before the government can circulate an RFP to which we can respond. Furthermore, the maintenance of our government contracts requires the continued acceptance of enabling legislation and any implementing regulations. In the past, various entities that use the portals we operate to obtain government products and services have challenged the authority of governments to electronically provide these products and services exclusively through portals like those we operate. A successful challenge in the future could result in a proliferation of alternative ways to obtain these products and services, which would harm our business, results of operations and financial condition. The repeal or modification of any enabling legislation would also harm our business, results of operations and financial condition. BECAUSE A LARGE PORTION OF OUR BUSINESS RELIES ON A CONTRACTUAL BIDDING PROCESS WHOSE PARAMETERS ARE ESTABLISHED BY GOVERNMENTS, THE LENGTH OF OUR SALES CYCLES IS UNCERTAIN AND CAN LEAD TO SHORTFALLS IN REVENUES Our dependence on a bidding process to initiate many new projects, the parameters of which are established by governments, results in uncertainty in our sales cycles because the duration and the procedures for each bidding process vary significantly according to each government entity's policies and procedures. The time between the date of initial contact with a government for a bid and the award of the bid may range from as little as 180 days to up to 36 months. The bidding process is subject to factors over which we have little or no control, including: - political acceptance of the concept of government agencies contracting with third parties to distribute public information, which has been offered traditionally only by the government agencies often without charge; - the internal review process by the government agencies for bid acceptance; - the need to reach a political accommodation among various interest groups; - changes to the bidding procedure by the government agencies; - changes to state legislation authorizing government's contracting with third parties to distribute public information; - changes in government administrations; - the budgetary restrictions of government entities; - the competition generated by the bidding process; and - the possibility of cancellation or delay by the government entities. Even though we have diversified our business to include services and products that are not subject to the bidding process, we are still dependent on the bidding process for a significant part of our business. Therefore, any material delay in the bidding process, changes to the bidding practices and policies, the failure to receive the bid or the failure to execute a contract may disrupt our financial results for a particular period and harm our business and financial condition. OUR APPLICATION SERVICES DIVISION HAS INCURRED LOSSES UNDER ITS FIXED-FEE CONTRACTS, AND OUR RESULTS OF OPERATIONS COULD BE HARMED IF THE COSTS THAT OUR RECENTLY CREATED NIC CONQUEST BUSINESS INCURS TO MEET CONTRACTUAL COMMITMENTS EXCEED OUR CURRENT ESTIMATES Our Application Services Division developed and implemented back-office government software applications for a fixed development fee. Since we combined our Application Services Division with Conquest Softworks, LLC in January 2000, we have expanded our applications to include back-end software applications and services for electronic filings and document management solutions for governments at a fixed fee. Our NIC Conquest business has assumed most of the contractual obligations of our Application Services Division. In the fourth quarter of 1998, we determined that the balance of revenues remaining to be recognized under our existing Application Services Division contractual obligations was not expected to cover anticipated costs of developing and implementing the related applications. Estimated costs in excess of fixed contract prices of $1.3 million for completing these applications were expensed in the fourth quarter of 1998. We accrued an additional $1.1 million of anticipated losses in 1999 based on revised estimates. It is possible that NIC Conquest's costs will similarly exceed revenues in the future, as a result of unforeseen difficulties in the creation of an application called for in a contract, unforeseen challenges in ensuring compatibility with existing systems, rising development and personnel costs or other reasons. If this occurs, our business, results of operations and financial condition could be harmed. ENTRANCE OF POTENTIAL COMPETITORS INTO THE MARKETPLACE COULD HARM OUR ABILITY TO MAINTAIN OR IMPROVE OUR POSITION IN THE MARKET Many companies exist that provide one or more parts of the products and services we offer. In most cases, the principal substitute for our services is a government-designed and managed approach that integrates other vendors' technologies, products and services. Companies that have expertise in marketing and providing technical services to government entities have begun to compete with us by further developing their services and increasing their focus on this piece of their business and market shares. Examples of companies that may compete with us are the following: - large systems integrators, including American Management Systems, Inc., Sapient Corporation and SAIC; - traditional software applications developers, including Microsoft and Oracle; - traditional consulting firms, including IBM, KPMG Peat Marwick, Deloitte & Touche and Andersen Consulting; - providers of ecommerce applications, including Ariba, Commerce One, PurchasePro.com and Digital Commerce Corporation; - consumer-oriented government portal companies, including govWorks.com and EZgov.com; and - Web service companies, including Whittman-Hart/USWeb, AppNet Systems, Inc., and Verio Inc. Many of our potential competitors are national or international in scope and may have greater resources than we do. These resources could enable our potential competitors to initiate severe price cuts or take other measures to gain market share. Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing and other resources than us, significantly greater name recognition and a larger installed base of customers. Additionally, in some geographic areas, we may face competition from smaller consulting firms with established reputations and political relationships with potential government clients. If we do not compete effectively or if we experience any pricing pressures, reduced margins or loss of market share resulting from increased competition, our business and financial condition may be harmed. THE SEASONALITY OF USE FOR SOME OF OUR ELECTRONIC GOVERNMENT PRODUCTS AND SERVICES MAY HARM OUR FOURTH QUARTER RESULTS OF EACH CALENDAR YEAR The use of some of our electronic government products and services is seasonal, particularly the accessing of drivers' records, resulting in lower revenues in the fourth quarter of each calendar year, due to the smaller number of business days in this quarter and a lower volume of government-to-business and government-to-citizen transactions during the holiday period. As a result, seasonality is likely to cause our quarterly results to fluctuate, which could harm our business and financial condition and could harm the trading price of our common stock. OUR QUARTERLY RESULTS OF OPERATIONS ARE VOLATILE AND DIFFICULT TO PREDICT. IF WE FAIL TO MEET THE EXPECTATIONS OF PUBLIC MARKET ANALYSTS OR INVESTORS, THE MARKET PRICE OF OUR COMMON STOCK MAY DECREASE SIGNIFICANTLY Our future revenues and results of operations may vary significantly from quarter to quarter due to a number of factors, many of which are outside of our control, and any of which may harm our business. These factors include: - the commencement, completion or termination of contracts during any particular quarter; - the introduction of new electronic government products and services by us or our competitors; - technical difficulties or system downtime affecting the Internet generally or the operation of our electronic government products and services; - the amount and timing of operating costs and capital expenditures relating to the expansion of our business operations and infrastructure; - the result of negative cash flows due to capital investments; and - the incurrence of significant charges related to acquisitions. Due to the factors noted above, our revenues in a particular quarter may be lower than we anticipate and if we are unable to reduce spending in that quarter, our results of operations for that quarter may be harmed. You should not rely on quarter-to-quarter comparisons of our results of operations as an indication of future performance. It is possible that in some future periods our results of operations may be below the expectations of public market analysts and investors. If this occurs, the price of our common stock may decline. IF WE FAIL TO COORDINATE OR EXPAND OUR OPERATIONAL PROCEDURES AND CONTROLS, WE MAY NOT EFFECTIVELY MANAGE OUR GROWTH Our growth rate may increase rapidly in response to the acceptance of our products and services under new or existing government contracts. If we cannot manage our growth effectively, we may not be able to coordinate the activities of our technical, accounting and marketing staffs, and our business could be harmed. We intend to plan for the acceptance of new bids by a number of governmental entities so that we may be ready to begin operations as soon as possible after acceptance of a bid. Additionally, we plan to continue our expansion of electronic filing services into new local, state and federal markets. As part of this plan of growth, we must implement new operational procedures and controls to expand, train and manage our employees and to coordinate the operations of our various subsidiaries. If we cannot manage the growth of our government portals, staff, software installation and maintenance teams, offices and operations, our business may be harmed. WE MAY BE UNABLE TO HIRE, INTEGRATE OR RETAIN QUALIFIED PERSONNEL The recent growth in our business has resulted in an increase in the responsibilities for both existing and new management personnel. Some of our personnel are presently serving in more than one executive capacity. The loss of any of our executives could harm our business. In addition, we expect that we will need to hire additional personnel in all areas in 2000, including general managers for new operations in jurisdictions in which we obtain contracts. Competition for personnel in the Internet industry is intense. We may not be able to retain our current key employees or attract, integrate or retain other qualified employees in the future. If we do not succeed in attracting new personnel or integrating, retaining and motivating our current personnel, our business could be harmed. In addition, new employees generally require substantial training in the presentation, policies and positioning of our government portals and other services. This training will require substantial resources and management attention. TO BE SUCCESSFUL, WE MUST DEVELOP AND MARKET COMPREHENSIVE, EFFICIENT, COST-EFFECTIVE AND SECURE ELECTRONIC ACCESS TO PUBLIC INFORMATION AND NEW PRODUCTS AND SERVICES Our success depends in part upon our ability to attract a greater number of Internet users to access public information electronically by delivering a comprehensive composite of public information and an efficient, cost-effective and secure method of electronic access and transactions. Moreover, in order to increase revenues in the future, we must continue to develop products and services that businesses and citizens will find valuable, and there is no guarantee that we will be able to do so. If we are unable to develop products and services that allow us to attract, retain and expand our current user base, our revenues and future results of operations may be harmed. We cannot assure you that the products and services we offer will appeal to a sufficient number of Internet users to generate continued revenue growth. For example, we cannot assure you that the use of eFed, our online procurement software services, by local, state and federal governments will continue to grow. Our ability to attract Internet users to our government portals depends on several factors, including: - the comprehensiveness of public records available through our government portals; - the perceived efficiency and cost-effectiveness of accessing public records electronically; - the perceived efficacy of online government-to-business procurement solutions; - the effectiveness of security measures; and - the increased usage and continued reliability of the Internet. DEFICIENCIES IN OUR PERFORMANCE UNDER A GOVERNMENT CONTRACT COULD RESULT IN CONTRACT TERMINATION, REPUTATIONAL DAMAGE OR FINANCIAL PENALTIES Each government entity with which we contract has the authority to require an independent audit of our performance. The scope of audits could include inspections of income statements, balance sheets, fee structures, collections practices, service levels and our compliance with applicable laws, regulations and standards. We cannot assure you that a future audit will not find any material performance deficiencies that would result in an adjustment to our revenues and result in financial penalties. Moreover, the consequent negative publicity could harm our reputation among other governments with which we would like to contract. All of these factors could harm our business, results of operations and financial condition. WE MAY BE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS We rely on a combination of nondisclosure and other contractual arrangements with governments, our employees and third parties, and privacy and trade secret laws to protect and limit the distribution of the proprietary applications, documentation and processes we have developed in connection with the electronic government products and services we offer. Despite our precautions, third parties may succeed in misappropriating our intellectual property or independently developing similar intellectual property. If we fail to adequately protect our intellectual property rights and proprietary information or if we become involved in litigation relating to our intellectual property rights and proprietary technology, our business could be harmed. Any actions we take may not be adequate to protect our proprietary rights and other companies may develop technologies that are similar or superior to our proprietary technology. Additionally, it is possible that we could in the future become subject to claims alleging infringement of third-party intellectual property rights. Any claims could subject us to costly litigation, and may require us to pay damages and develop non-infringing intellectual property or acquire licenses to the intellectual property that is the subject of the alleged infringement. Additionally, licenses may not be available on acceptable terms or at all. IF THIRD PARTIES CLAIM THAT WE INFRINGE UPON THEIR INTELLECTUAL PROPERTY, OUR ABILITY TO USE CERTAIN TECHNOLOGIES AND PRODUCTS COULD BE LIMITED AND WE MAY INCUR SIGNIFICANT COSTS TO RESOLVE THESE CLAIMS Litigation regarding intellectual property rights is common in the Internet and software industries. We expect third-party infringement claims involving Internet technologies and software products and services to increase. If an infringement claim is filed against us, we may be prevented from using certain technologies and may incur significant costs resolving the claim. We have in the past received letters suggesting that we are infringing on the intellectual rights of others, and we may from time to time encounter disputes over rights and obligations concerning intellectual property. Although we believe that our intellectual property rights are sufficient to allow us to market our existing products without incurring liability to third parties, we cannot assure you that our products and services do not infringe on the intellectual property rights of third parties. In addition, we have agreed, and may agree in the future, to indemnify certain of our customers against claims that our products infringe upon the intellectual property rights of others. We could incur substantial costs in defending ourselves and our customers against infringement claims. In the event of a claim of infringement, we and our customers may be required to obtain one or more licenses from third parties. We cannot assure you that we or our customers could obtain necessary licenses from third parties at a reasonable cost or at all. UPON THE COMPLETION OF THE INITIAL TERM OF OUR GOVERNMENT CONTRACTS, GOVERNMENTS OBTAIN A PERPETUAL RIGHT OF USE LICENSE TO OUR SOFTWARE PROGRAMS AND OTHER APPLICATIONS, WHICH THEY COULD USE TO OPERATE THE PORTALS THEMSELVES After termination of our contracts, it is possible that governments and their successors and affiliates may use their right of use license rights to the software programs and other applications we have developed for them in the operation of their portals to operate the portals themselves. Inadvertently, they also may allow our intellectual property or other information to fall into the hands of third parties, including our competitors. WE MAY NEED MORE WORKING CAPITAL TO EXPAND OUR BUSINESS We anticipate that our current resources, combined with the net proceeds from this offering, will be sufficient to meet our present working capital and capital expenditure requirements for at least the next 18 months following the date of this prospectus. However, we may need to raise additional capital before this period ends to do the following: - expand our services and products offerings; - acquire complementary businesses or technologies; - support our expansion into other states, cities, municipalities and federal agencies and internationally; and - respond to competitive pressures. Our future liquidity and capital requirements will depend upon numerous factors, including the success of our existing and new product and service offerings and potentially competing technological and market developments. We may be required to raise additional funds through public or private financing, strategic relationships or other arrangements. We cannot assure you that such additional funding, if needed, will be available on terms acceptable to us, or at all. If adequate funds are not available on acceptable terms, our ability to develop or enhance our products and services, take advantage of future opportunities or respond to competitive pressures would be significantly limited. This limitation could harm our business, results of operations and financial condition. WE MAY BE UNABLE TO INTEGRATE NEW TECHNOLOGIES AND INDUSTRY STANDARDS EFFECTIVELY Our future success will depend on our ability to enhance and improve the responsiveness, functionality and features of our products and services in accordance with industry standards and to address the increasingly sophisticated technological needs of our customers on a cost-effective and timely basis. Our ability to remain competitive will depend, in part, on our ability to: - enhance and improve the responsiveness, functionality and other features of the government portals we offer; - continue to develop our technical expertise; - develop and introduce new services, applications and technology to meet changing customer needs and preferences; and - influence and respond to emerging industry standards and other technological changes in a timely and cost-effective manner. We cannot assure you that we will be successful in responding to the above technological and industry challenges in a timely and cost-effective manner. If we are unable to integrate new technologies and industry standards effectively, our results of operations could be harmed. WE COULD STILL FACE PROBLEMS RELATED TO THE YEAR 2000 ISSUE To date, our customers have not reported any problems with our government portals or software applications and products as a result of the commencement of the year 2000, and we have not experienced any impairment in our internal operations due to the year 2000 issue. Nevertheless, computer experts have warned that there may still be residual consequences stemming from the change in centuries and, if these consequences become widespread, they could result in claims against us, a decrease in revenues generated by our government portals and software applications and products and services, increased operating expenses and other business interruptions. RISKS RELATED TO THE INTERNET INDUSTRY WE DEPEND ON THE INCREASING USE OF THE INTERNET AND ON THE GROWTH OF ONLINE GOVERNMENT INFORMATION SYSTEMS. IF THE USE OF THE INTERNET AND ELECTRONIC GOVERNMENT INFORMATION SYSTEMS DOES NOT GROW AS ANTICIPATED, OUR BUSINESS WILL BE SERIOUSLY HARMED Our business depends on the increased acceptance and use of the Internet as a medium for accessing public information and completing government filings and procurement contracts. Rapid growth in the use of the Internet is a recent phenomenon. As a result, acceptance and use may not continue to develop at historical rates and a sufficiently broad base of individual and business customers may not adopt or continue to use the Internet as a medium for accessing government portals and other online services. Demand and market acceptance for recently introduced services and products over the Internet are subject to a high level of uncertainty, and there exist few proven services and products. Our business would be seriously harmed if: - Use of the Internet and other online services does not continue to increase or increases more slowly than expected; or - The technology underlying the Internet and other online services does not effectively support any expansion that may occur. IF THE INTERNET INFRASTRUCTURE FAILS TO DEVELOP OR BE ADEQUATELY MAINTAINED, OUR BUSINESS WOULD BE HARMED BECAUSE USERS MAY NOT BE ABLE TO ACCESS OUR GOVERNMENT PORTALS Our success depends on the increase in Internet usage generally and in particular as a means to access public information electronically. This in part requires the development and maintenance of the Internet infrastructure. If this infrastructure fails to develop or be adequately maintained, our business would be harmed because users may not be able to access our government portals. Among other things, this development and maintenance will require a reliable network backbone with the necessary speed, data capacity, security and timely development of complementary products for providing reliable Internet access and services. The Internet has experienced, and is expected to continue to experience, significant growth in the number of users and amount of traffic. If the Web continues to experience increased numbers of users, frequency of use or increased bandwidth requirements, the Internet infrastructure may not be able to support these increased demands or perform reliably. The Internet has experienced a variety of outages and other delays as a result of damage to portions of its infrastructure, and could face such outages and delays in the future. These outages and delays could reduce the level of Internet usage and traffic on our government portals. Such outages and delays would also hinder our customers' ability to file UCC documents online, renew professional licenses electronically, file fuel tax applications and complete online government purchase orders and requisitions. In addition, the Internet could lose its viability due to delays in the development or adoption of new standards and protocols to handle increased levels of activity or due to increased governmental regulation. If the Internet infrastructure is not adequately developed or maintained, use of our government portals and our government-to-citizen and government-to-business services may be reduced. WE MAY BE HELD LIABLE FOR CONTENT THAT WE OBTAIN FROM GOVERNMENT AGENCIES Because we aggregate and distribute sometimes private and sensitive public information over the Internet, we may face potential liability for defamation, libel, negligence, invasion of privacy, copyright or trademark infringement, and other claims based on the nature and content of the material that is published on our government portals. Most of the agreements through which we obtain consent to disseminate this information do not contain indemnity provisions in our favor. These types of claims have been brought, sometimes successfully, against online services and Web sites in the past. We cannot assure you that our general liability insurance will be adequate to indemnify us for all liability that may be imposed. Any liability that is not covered by our insurance or is in excess of our insurance coverage could severely harm our business operations and financial condition. CONCERNS OVER TRANSACTIONAL SECURITY MAY HINDER THE GROWTH OF OUR BUSINESS A significant barrier to electronic commerce is the secure transmission of confidential information over public networks. Any breach in our security could expose us to a risk of loss or litigation and possible liability. We rely on encryption and authentication technology licensed from third parties to provide secure transmission of confidential information. As a result of advances in computer capabilities, new discoveries in the field of cryptography or other developments, a compromise or breach of the algorithms we use to protect customer transaction data may occur. Because we provide information released from various government entities, we may represent an attractive target for security breaches. A compromise of our security or a perceived compromise of our security could severely harm our business. A party who is able to circumvent our security measures could misappropriate proprietary information, including customer credit card information, or cause interruptions or direct damage to our government portals. Also, should hackers obtain sensitive data and information, or create bugs or viruses in an attempt to sabotage the functionality of our products and services, we may receive negative publicity, incur liability to our customers or lose the confidence of the governments with which we contract, any of which may cause the termination or modification of our government contracts. We may be required to expend significant capital and other resources to protect against the threat of security breaches or to alleviate problems caused by these breaches. However, protection may not be available at a reasonable price or at all. GOVERNMENTAL REGULATION OF THE INTERNET MAY RESTRICT THE OPERATION AND GROWTH OF OUR BUSINESS There are currently few laws or regulations that specifically regulate communications or commerce on the Internet. Laws and regulations may be adopted in the future, however, that address these issues including user privacy, pricing, and the characteristics and quality of products and services. An increase in regulation or the application of existing laws to the Internet could significantly increase our cost of operations and harm our business. For example, the Federal Communications Commission, or FCC, is currently reviewing its regulatory position that Internet access service is not "telecommunications" and may decide that Internet service providers must pay a percentage of their gross revenues as a "universal service contribution." If the FCC were to require universal service contributions from providers of Internet access or Internet backbone services, our costs of doing business may increase, and we may not be able to recover these costs from our customers. Additionally, state public utility commissions generally have declined to review potential regulation of such services, but may chose to do so in the future. As a result, our business and financial condition could be harmed. OUR SYSTEMS MAY FAIL OR LIMIT USER TRAFFIC, WHICH COULD HARM OUR BUSINESS, RESULTS OF OPERATIONS AND FINANCIAL CONDITION Our communications hardware and computer hardware operations for delivering our electronic government services are located individually in each state or city where we provide those services. We cannot assure you that during the occurrence of fire, floods, earthquakes, power loss, telecommunications failures, break-ins and similar events that the modem banks and direct dial-up connections we have to serve as back-up systems will not prevent damage to our systems or cause interruptions to our services. Computer viruses, electronic break-ins or other similar disruptive problems could cause users to stop visiting our government portals and could cause our clients to terminate agreements with us. If any of these circumstances occurred, our business could be harmed. Our insurance policies may not adequately compensate us for any losses that may occur due to any failures of or interruptions in our systems. Our government portals must accommodate a high volume of traffic and deliver frequently updated information. These government portals may experience interruptions due to any failure or delay by government agencies in the transmission or receipt of this information. Due to holidays and technical problems with state computer systems, our Web sites have experienced slower response times or decreased traffic in the past and may experience the same incidents in the future. In addition, our users depend on Internet service providers, online service providers and other Web site operators for access to our government portals and other online government-to-citizen and government-to-business services. Many of these providers and operators have experienced significant outages in the past due to system failures unrelated to our systems, holidays and heavy user traffic, and could experience the same outages, delays and other difficulties in the future. Any of these system failures could harm our business, results of operations and financial condition. RISKS RELATED TO THIS OFFERING OUR EXECUTIVE OFFICERS, DIRECTORS AND MAJOR SHAREHOLDERS WILL RETAIN SIGNIFICANT CONTROL OVER US AFTER THIS OFFERING, WHICH WILL ALLOW THEM TO INFLUENCE THE OUTCOME OF MATTERS SUBMITTED TO SHAREHOLDERS FOR APPROVAL After this offering, executive officers, directors and holders of 5% or more of our outstanding common stock will, in the aggregate, own approximately 57.5% of our outstanding common stock. In addition, as of January 31, 2000, 27,469,884 shares of our outstanding common stock have been placed in a voting trust, representing approximately 51.6% of our outstanding common stock prior to this offering. The trustees of this voting trust are Messrs. Fraser and Hartley, both of whom serve as directors of our company. As a result, Messrs. Fraser and Hartley have, among other rights, the ability to control the election of directors and approve corporate actions that must be submitted for a vote of shareholders. The voting trust is selling 2,905,378 shares of common stock in this offering, which will reduce the number of shares it holds to 24,564,506, or approximately 42.8% of our outstanding common stock based on the number of shares of common stock outstanding after this offering. As co-trustees of the voting trust, Messrs. Fraser and Hartley will have the ability to control up to 42.8% of the outstanding voting control of the common shares. In addition, Jeffery S. Fraser, our Chairman and former Chief Executive Officer, is selling 676,441 shares of common stock in this offering, which will reduce the number of shares over which he has direct economic benefit to 5,719,251, or approximately 10.0% of our outstanding common stock after this offering. The interests of these affiliates may conflict with the interests of other shareholders, and the actions they take or approve may be contrary to those desired by the other shareholders. This concentration of ownership may also have the effect of delaying, preventing or deterring an acquisition of our company by a third party. OUR MANAGEMENT WILL RETAIN BROAD DISCRETION IN THE USE OF PROCEEDS FROM THIS OFFERING AND MAY USE THE PROCEEDS IN WAYS THAT MAY NOT INCREASE OUR RESULTS OF OPERATIONS OR MARKET VALUE We anticipate that we may use all of the net proceeds from the sale of the common stock for any or all of the following purposes: - to pursue new acquisitions, strategic investments, strategic alliances and partnerships; - to create new products and services; - to increase our new market development efforts by further expanding into local, state and international markets; - to further develop common infrastructure and operating platforms; and - to increase marketing efforts aimed at raising transaction volume. We intend to use any proceeds that remain for working capital and general corporate purposes. However, our management will retain significant flexibility in applying the net proceeds of this offering and may use the proceeds in ways in which you do not agree. Until the proceeds are needed, we plan to invest them in investment-grade, interest-bearing securities. The failure of our management to apply such funds effectively could harm our business. THE SIGNIFICANT NUMBER OF SHARES OF COMMON STOCK THAT WILL BE ELIGIBLE FOR SALE IN THE NEAR FUTURE MAY HARM THE MARKET PRICE OF OUR COMMON STOCK Sales of a substantial number of shares of our common stock in the public market after this offering could cause the market price of our common stock to decline. Additionally, the perception that such sales could occur could adversely affect the market price of our common stock. These factors also could make it more difficult for us to raise funds through future offerings of our common stock. Based on the number of shares of common stock outstanding as of December 31, 1999, there will be 57,300,632 shares of common stock outstanding immediately after this offering. All of the shares sold in this offering will be freely transferable without restriction or further registration under the Securities Act, except for shares purchased by our "affiliates" as defined in Rule 144 of the Securities Act. Upon completion of this offering, 265,838 shares will be "restricted securities" as defined in Rule 144. These restricted securities may be sold in the future without registration under the Securities Act to the extent permitted under Rule 144, Rule 701 or an exemption under the Securities Act. In addition, 515,100 shares of our common stock will be tradeable after satisfaction of certain performance conditions by our eFed subsidiary. In connection with this offering, all of our executive officers, directors and holders of more than 5% of our outstanding common stock have agreed not to sell their shares without the prior written consent of Credit Suisse First Boston Corporation for a period not to exceed 90 days from the date of this prospectus, and others are subject to market stand-off agreements. As of December 31, 1999, 3,890,331 shares of common stock were issuable upon exercise of outstanding options, assuming the issuance and sale of 84,593 and 50,669 shares of common stock in this offering after the exercise of options by James B. Dodd and Kevin C. Childress, respectively. Of those options, options to purchase 810,614 shares will be vested and fully exercisable 90 days after commencement of this offering. OUR STOCK PRICE, LIKE THAT OF OTHER INTERNET COMPANIES, MAY BE HIGHLY VOLATILE The stock market has experienced significant price and volume fluctuations and the market prices of securities of technology companies, particularly Internet-related companies, have been highly volatile, with this volatility often unrelated to the operating performance of such companies. Investors may not be able to resell their shares of our common stock at or above the public offering price. In the past, securities class action litigation has often been instituted against a company following periods of volatility in the company's stock price. This type of litigation could result in substantial costs and could divert our management's attention and resources. Our stock price could fluctuate in response to a variety of factors, including: - actual or anticipated variations in quarterly results of operations; - announcements of new technological innovations, contracts or applications; - announcements of significant acquisitions, strategic partnerships, joint venture or capital commitments; - new products and services offered by us or our competitors; - changes in financial estimates by securities analysts; - additions or departures of key personnel; and - other events or factors that may be beyond our control. ANTI-TAKEOVER PROVISIONS IN OUR CHARTER DOCUMENTS COULD PREVENT OR DELAY A CHANGE OF CONTROL AND, AS A RESULT, NEGATIVELY IMPACT OUR SHAREHOLDERS Our articles of incorporation provide that our board of directors may not for a period of three years engage in a business combination with an interested shareholder unless the business combination is approved in a prescribed manner. Furthermore, our bylaws limit the ability of shareholders to raise matters at a meeting of shareholders without giving advance notice. The anti-takeover provisions in our articles of incorporation and bylaws may have the effect of delaying, deterring or preventing changes in control or management of our company, even if such change in control or management would be beneficial to shareholders. These provisions also could limit the price that some investors might be willing to pay in the future for shares of our common stock.

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+RISK FACTORS You should consider carefully the following risks, together with all other information included in this prospectus, before you decide to buy our common stock. Please keep these risks in mind when reading this prospectus, including any forward-looking statements appearing in this prospectus. If any of the following risks actually occurs, our business, financial condition or results of operations would likely suffer materially. As a result, the trading price of our common stock may decline, and you could lose all or part of the money you paid to buy our common stock. Risks relating to our business Our limited operating history makes it difficult to evaluate our business and prospects We commenced operations in March 1998 and only recently began to market and sell our services. We began offering commercial service in Stamford, Connecticut in May 1998. Accordingly, you have limited information about our company with which to evaluate our business, strategies and performance and an investment in our common stock. Because the high-speed data communications industry is new and rapidly evolving, we cannot predict its future growth or ultimate size The high-speed data communications industry is in the early stages of development and is subject to rapid and significant technological change. Since this industry is new and because the technologies available for high-speed data communications services are rapidly evolving, we cannot accurately predict the rate at which the market for our services will grow, if at all, or whether emerging technologies will render our services less competitive or obsolete. If the market for our services fails to develop or grows more slowly than anticipated, our business, prospects, financial condition and results of operations could be materially adversely affected. Many providers of high-speed data communication services are testing products from numerous suppliers for various applications, and these suppliers have not broadly adopted an industry standard. In addition, certain industry groups are in the process of trying to establish standards which could limit the types or speeds of the technologies we could use. Certain critical issues concerning commercial use of DSL technology for Internet access, including security, reliability, ease and cost of access and quality of service, remain unresolved and may impact the growth of these services. We have incurred losses and have experienced negative operating cash flow to date and expect our losses and negative operating cash flow to continue and to increase We have incurred significant losses and experienced negative operating cash flow for each month since our formation. We expect to continue to incur significant losses and negative operating cash flow for the foreseeable future. If our revenue does not grow as expected or capital and operating expenditures exceed our plans, our business, prospects, financial condition and results of operations will be materially adversely affected. As of December 31, 1999, we had an accumulated deficit of approximately $27,180,000. We cannot be certain if or when we will be profitable or if or when we will generate positive operating cash flow. We expect our operating expenses to increase significantly as we expand our business. In addition, we expect to make significant additional capital expenditures in 2000 and in subsequent years. We also expect to substantially increase our operating expenditures, particularly network and operations and sales and marketing expenditures, as we implement our business plan. However, our revenue may not increase despite this increased spending. 4 <PAGE> Our business model is unproven, and may not be successful We do not know whether our business model and strategy will be successful. If the assumptions underlying our business model are not valid or we are unable to implement our business plan, achieve the predicted level of market penetration or obtain the desired level of pricing of our services for sustained periods, our business, prospects, financial condition and results of operations could be materially adversely affected. We have adopted a different strategy than certain other DSL providers. We focus on selling directly to small and medium sized businesses in second and third tier cities. In contrast, certain other DSL providers sell services primarily to Internet service providers and others who, in turn, resell these services to end users through their sales forces. In addition, many other DSL providers are currently focused primarily on offering their services in large metropolitan areas. Certain of our target markets are within the larger metropolitan areas where other DSL providers are focused on providing service. Our unproven business model makes it difficult to predict the extent to which our services will achieve market acceptance. To be successful, we must deploy our network in a significant number of our selected markets and convince our target customers to utilize our service. It is possible that we may never be able to deploy our network as planned or achieve significant market acceptance, favorable operating results or profitability. Our failure to achieve or sustain market acceptance at desired pricing levels could impair our ability to achieve profitability or positive cash flow Prices for digital communication services have fallen historically, a trend we expect will continue. Accordingly, we cannot predict to what extent we may need to reduce our prices to remain competitive or whether we will be able to sustain future pricing levels as our competitors introduce competing services or similar services at lower prices. Our failure to achieve or sustain market acceptance at desired pricing levels could impair our ability to achieve profitability or positive cash flow, which would have a material adverse effect on our business, prospects, financial condition and results of operations. If we fail to recruit qualified personnel in a timely manner and retain our employees, we will not be able to execute our business plan and our business will be harmed To execute our business plan, we need to hire a substantial number of qualified personnel, particularly sales and marketing, engineering and other technical personnel. If we are unable to recruit qualified personnel in a timely manner or to retain our employees, we will not be able to execute our business plan. In particular, if we are unable to recruit and retain a sufficient number of qualified personnel, including many who must be recruited to work locally in the new markets where we provide or intend to provide service, we may not be able to commence service as quickly as we expect in those new markets and, as a result, our revenue growth may be lower than we expect and our business may be harmed. Our industry is characterized by intense competition for, and aggressive recruiting of, skilled personnel, as well as a high level of employee mobility. Many of our future employees must be recruited to work locally in the new markets where we intend to establish a presence. The combination of our local sales and marketing strategy and the competitive nature of our industry may make it difficult to hire qualified personnel on a timely basis and to retain our employees. Our management team has little experience working together, and the loss of key personnel could adversely affect our business We depend on a small number of executive officers and other members of senior management to work effectively as a team, to execute our business strategy and business plan, and to manage employees located throughout the United States. The loss of key managers or their failure to work 5 <PAGE> effectively as a team could have a material adverse effect on our business and prospects. We do not have employment agreements with any of our executive officers, so any of these individuals may terminate employment at any time. Our failure to establish the necessary infrastructure to support our business and to manage our growth could strain our resources and adversely affect our business and financial performance Our business plan anticipates that we will provide service in a significant number of new cities and add a significant number of new employees in geographically-dispersed areas. This rapid growth will continue to place a significant strain on our management, financial controls, operations, personnel and other resources. Our failure to manage our rapid growth could have a material adverse effect on our ability to integrate expanding operations, the quality of our services and our ability to recruit, manage and retain key personnel. If we do not institute adequate financial and reporting systems, managerial controls, and procedures to manage and operate from multiple geographically-dispersed locations, our operations will be materially and adversely affected. We have deployed operations support systems to help manage customer service, bill customers, process customer orders and coordinate with vendors and contractors. The subsequent integration and enhancement of these systems could be delayed or cause disruptions in service or billing. In addition, we have recently implemented a new financial and reporting system which will interact with our operations support systems. To manage our growth effectively, we must continue to successfully implement these systems on a timely basis, and continually expand and upgrade these systems as our operations expand. Disappointing quarterly revenue or operating results could cause the price of our common stock to fall Our quarterly revenue and operating results are difficult to predict and may fluctuate significantly from quarter to quarter. If our quarterly revenue or operating results fall below the expectations of investors or security analysts, the price of our common stock could fall substantially. Our quarterly revenue and operating results may fluctuate as a result of a variety of factors, many of which are outside our control, including: . the amount and timing of expenditures relating to the rollout of our infrastructure and services; . the ability to obtain and the timing of necessary regulatory approvals; . the rate at which we are able to attract customers within our target markets and our ability to retain these customers at sufficient aggregate revenue levels; . our ability to deploy our network on a timely basis; . the availability of financing to continue our expansion; . the technical difficulties or network service interruptions; . the availability of space in traditional telephone companies' central offices and timing of the installation of our equipment in those spaces; and . the introduction of new services or technologies by our competitors and resulting pressures on the pricing of our service. The failure of our customers to pay their bills on a timely basis could adversely affect our cash flow Our target customers consist of small and medium sized businesses. We anticipate having to bill and collect numerous relatively small customer accounts. We may experience difficulty in 6 <PAGE> collecting amounts due on a timely basis. Our failure to collect accounts receivable owed to us by our customers on a timely basis could have a material adverse effect on our business, financial condition and cash flow. Our failure to develop and maintain good relationships with marketing partners in a local service market could adversely affect our ability to obtain and retain customers in that market In addition to marketing through our direct sales force, we rely on relationships with local marketing partners, such as integrators of computer systems and networks and consultants. These partners recommend our services to their clients, provide us with referrals and help us build a local presence in each market. We may not be able to identify, and maintain good relationships with, quality marketing partners and we cannot assure you that they will recommend our services rather than our competitors' services to their customers. Our failure to identify and maintain good relationships with quality marketing partners could have a material adverse effect on our ability to obtain and retain customers in a market and, as a result, our business would suffer. Our success depends on negotiating and entering into interconnection agreements with traditional telephone companies We must enter into and renew interconnection agreements with traditional telephone companies in each of our target markets in order to provide service in that market. These agreements govern, among other things, the price and other terms regarding our location of equipment in the offices of traditional telephone companies which house telecommunications equipment and from which local telephone service is provided, known as central offices, and our lease of copper telephone lines that connect those central offices to our customers. To date, we have entered into agreements with Ameritech, Bell Atlantic, BellSouth, Cincinnati Bell, GTE, SBC Communications, Sprint and US West, which govern our relationships in 48 states and the District of Columbia. Delays in obtaining interconnection agreements would delay our entrance into target markets and could have a material adverse effect on our business and prospects. Our interconnection agreements generally have limited terms of one to two years and we cannot assure you that new agreements will be negotiated or that existing agreements will be extended on terms favorable to us. Interconnection agreements must be approved by state regulators and are also subject to oversight by the FCC and the courts. These governmental authorities may modify the terms or prices of our interconnection agreements in ways that could adversely affect our ability to deliver service and our business and results of operations. Failure to negotiate interconnection agreements with the traditional local telephone companies could lead to costly and lengthy arbitration which may not be resolved in our favor Under federal law, traditional telephone companies have an obligation to negotiate with us in good faith to enter into interconnection agreements. If no agreement can be reached, either side may petition the applicable state telecommunications regulators to arbitrate remaining disagreements. Arbitration is a costly and lengthy process that could delay our entry into markets and could harm our ability to compete. Interconnection agreements resulting from arbitration must be approved by state regulators. We cannot assure you that a state regulatory authority would resolve disputes in our favor. Failure to obtain space for our DSL equipment in the local telephone companies' central offices in our target markets could adversely affect our business Our strategy requires us to obtain space for our DSL equipment in those central offices of the traditional local telephone companies that already serve a large number of our target customers. 7 <PAGE> Failure to obtain required space to locate our equipment in those central offices, known as collocation space, on a timely basis could have a material adverse effect on our business. In addition to negotiating and entering into interconnection agreements with traditional telephone companies, we must obtain collocation space in each central office in which we intend to locate equipment. We may not be able to secure collocation space in the central offices of our choice on a timely basis. We expect that central office space will become increasingly scarce as demand increases. In addition, the terms of our collocation agreements are generally one to two years and are subject to certain renegotiation, renewal and termination provisions. Our success depends on traditional telephone companies providing acceptable transmission facilities and copper telephone lines We interconnect with and use the networks of traditional telephone companies to provide our services to our customers. We cannot assure you that these networks will be able to meet the telecommunications needs of our customers or maintain our service standards. We also depend on the traditional telephone companies to provide and maintain their transmission facilities and the copper telephone lines between our network and our customers' premises. Our dependence on traditional telephone companies could cause delays in establishing our network and providing our services. Any such delays could have a material adverse effect on our business. We lease copper telephone lines running from the central office of the traditional telephone companies to each customer's location. In many cases, the copper telephone lines must be specially conditioned by the telephone company to carry digital signals. We may not be able to lease a sufficient number of acceptable telephone lines on acceptable terms, if at all. Traditional telephone companies often rely on unionized labor and labor-related issues have in the past, and may in the future, adversely affect the services provided by the traditional telephone companies. We compete with the traditional local telephone companies on whom we depend Many of the traditional local telephone companies, including those created by AT&T's divestiture of its local telephone service business, have begun deploying DSL-based services. In addition, these companies also currently offer high-speed data communications services that use other technologies. Consequently, these companies have certain incentives to delay: . Our entry into, and renewals of, interconnection agreements with them, . Our access to their central offices to install our equipment and provide our services, . providing acceptable transmission facilities and copper telephone lines, and . our introduction and expansion of our services. Any such delays would negatively impact our ability to implement our business plan and harm our competitive position, business and prospects. We depend on two long distance carriers to connect our network Data is transmitted across our network via transmission facilities that we lease from MCI WorldCom and AT&T. Failure of these carriers to provide service or to provide quality service may interrupt the use of our services by our customers. In August 1999, the service provided by MCI WorldCom was interrupted for several days by a failure of their communications network. Several of our customers were without service or had poor service during this period. As a result, we issued approximately $21,000 in credits toward services to our customers. We cannot be sure that the MCI WorldCom and AT&T service will not be interrupted in the future. 8 <PAGE> Our success depends on contractors who install the equipment and wiring necessary to utilize our service in the central offices of traditional telephone companies and at our customers' premises We primarily utilize contractors to install necessary equipment and wiring in the central offices of traditional telephone companies and on our customers' premises. These installations must be completed on a timely basis and in a cost-efficient manner. Failure to retain experienced contractors to install the equipment and wiring or failure to complete these installations on a timely, cost-efficient basis could materially delay our growth or damage our reputation, our business and prospects and results of operations. If we are unable to retain contractors to provide these services, we will have to complete these installations ourselves, probably at a greater cost and with delay. We may be required to utilize numerous contractors as we expand our operations, which may divert management attention and result in delays in installations, cancellations, increased costs and lower quality. Intense competition in the high-speed data communication services market may negatively affect the number of our customers and the pricing of our services The high-speed data communication services market is intensely competitive. If we are unable to compete effectively, our business, prospects, financial condition and results of operations would be adversely affected. We expect the level of competition to intensify in the future, due, in part, to increasing consolidation in our industry. Our competitors use various high speed communications technologies for local access connections such as integrated services digital network, or ISDN, frame relay, T1, DSL services and wireless, satellite-based and cable networks. We expect significant competition from: . Other providers of DSL-based services like us, including Covad, Network Access Solutions, NorthPoint and Rhythms NetConnections; . Internet service providers, such as PSINet, Concentric Network and Flashcom, which offer high-speed access capabilities to complement their existing products and services; . Traditional local telephone companies, including the traditional telephone companies created by AT&T's divestiture of its local telephone service business, some of which have begun deploying DSL-based services and which provide other high-speed data communications services; . National long distance carriers, such as AT&T and MCI WorldCom, which are beginning to offer competitive DSL-based services; . Cable modem service providers, such as At Home, which are offering high- speed Internet access over cable networks and have positioned themselves to do the same for businesses; and . Providers utilizing alternative technologies, such as wireless and satellite-based data service providers. Many of our current and potential competitors have longer operating histories, greater brand name recognition, larger customer bases and substantially greater financial, technical, marketing, management, service support and other resources than we do. Therefore, they may be able to respond more quickly than we can to new or changing opportunities, technologies, standards or customer requirements. See "Business--Competition." 9 <PAGE> We may not be able to continue to grow our business if we do not obtain significant additional funds on acceptable terms during 2001 The actual amount and timing of our future capital requirements will depend on the demand for our services and regulatory, technological and competitive developments which could differ materially from our estimates. We may not be able to raise sufficient debt or equity capital on terms that we consider acceptable, if at all. If we are unable to obtain adequate funds on acceptable terms, our ability to deploy and operate our network, fund our expansion or respond to competitive pressures would be significantly impaired. We may incur significant amounts of debt in the future to implement our business plan and, if incurred, this indebtedness will create greater financial and operating risk and limit our flexibility We intend to seek additional debt financing in the future. We are not generating sufficient revenue or operating cash flow to fund our operations or to repay existing or expected debt. We may not be able to repay our current debt or any future debt. In addition, the terms of any future debt would likely contain additional restrictive covenants that would limit our ability to incur additional indebtedness and place other operating restrictions on our business. If we incur additional debt, we will be required to devote increased amounts of our cash flow to service indebtedness. This could require us to modify, delay or abandon the capital expenditures and other investments necessary to implement our business plan. We may be subject to risks associated with acquisitions We acquired Tycho Networks in December 1999 and may acquire additional businesses in the future, although we have no definitive agreements to do so at this time. An acquisition, including the recently-completed Tycho Networks acquisition, may not produce the revenue, earnings or business synergies that we anticipate, and an acquired business might not perform as we expect. If we pursue any future acquisition, our management could spend a significant amount of time and effort in identifying and completing the acquisition and may be distracted from the operation of our business. We will probably have to devote a significant amount of management resources to integrating any acquired business, including the business of Tycho Networks, with our existing operations, and that integration may not be successful. Our services are subject to federal, state and local regulation and changes in laws or regulations could adversely affect the way we operate our business The facilities we use and the services we offer are subject to varying degrees of regulation at the federal, state and/or local levels. Changes in applicable laws or regulations could, among other things, increase our costs, restrict our access to the central offices of the traditional telephone companies, or restrict our ability to provide our services. For example, the 1996 Telecommunications Act, which, among other things, requires traditional telephone companies to unbundle network elements and to allow competitors to locate their equipment in the telephone companies' central offices, is the subject of ongoing proceedings at the federal and state levels, litigation in federal and state courts, and legislation in federal and state legislatures. On remand from a decision of the U.S. Supreme Court that invalidated certain FCC regulations, the FCC recently re-established a list of unbundled network elements that must be provided to competitive companies such as us; however, this decision is still subject to petitions for reconsideration and to appeal. Also, FCC rules governing pricing standards for access to the networks of the traditional telephone companies are currently being challenged in federal court. In addition, an FCC order that found that advanced services, such as DSL, are subject to the market opening requirements of the 1996 Telecommunications Act was remanded by a federal appellate court to the FCC for further consideration. Another recent FCC order expanding collocation rights for DSL and other advanced service providers is also under review 10 <PAGE> on appeal. We cannot predict the outcome of the various proceedings, litigation and legislation or whether or to what extent these proceedings, litigation and legislation may adversely affect our business and operations. In addition, decisions by the FCC and state telecommunications regulators will determine some of the terms of our relationships with traditional telecommunications carriers, including the terms and prices of interconnection agreements, and access fees and surcharges on gross revenue from interstate and intrastate services. State telecommunications regulators determine whether and on what terms we will be authorized to operate as a competitive local exchange carrier in their state. In addition, local municipalities may require us to obtain various permits which could increase the cost of services or delay development of our network. Future federal, state and local regulations and legislation may be less favorable to us than current regulations and legislation and may adversely affect our businesses and operations. See "Business--Governmental Regulations." An FCC proposal to permit the traditional local telephone companies to offer DSL services through a less-regulated subsidiary could, if adopted, adversely affect our business plan by altering our relationship with the local telephone companies upon whose equipment we depend for access to customers In August 1998, the FCC proposed that the traditional local telephone companies should be permitted to create separate affiliates to provide DSL services that would operate under the relaxed regulatory treatment available to competitive DSL carriers. Under the separate affiliate proposal, traditional local telephone companies would be required to provide wholesale service to competitor DSL carriers at the same rates, terms and conditions that it provided to its separate affiliate. Though the outcome of this proceeding remains uncertain, the FCC adopted a condition to the merger of two traditional local telephone companies, SBC Communications and Ameritech, that will permit these companies to create separate affiliates to provide DSL services. In December 1999, the FCC accepted Bell Atlantic's commitment to create an advanced services affiliate as a condition to the Commission's decision to approve Bell Atlantic's application to offer interexchange long-distance services in New York state. Any final decision in this proceeding that alters our relationship with the traditional local telephone companies could adversely affect our ability to provide DSL services at a competitive price. Uncertain tax and other surcharges on our services may increase our payment obligations to federal and state governments Telecommunications providers are subject to a variety of federal and state surcharges and fees on their gross revenues from interstate and intrastate services. These surcharges and fees may be increased and other surcharges and fees not currently applicable to our services could be imposed on us. In either case, the cost of our services would increase and that could have a material adverse effect on our business, prospects, financial condition and results of operations. A breach of our network security could result in liability to us and deter customers from using our services Our network may be vulnerable to unauthorized access, computer viruses and other disruptive problems. Any of the foregoing problems could result in liability to us and deter customers from using our service. Unauthorized access could jeopardize the security of confidential information stored in the computer systems of our customers. Eliminating computer viruses and alleviating other security problems may require interruptions, delays or cessation of service to our customers, cause us to incur significant costs to remedy the problem, and divert management attention. We can provide no assurance that the security measures we have implemented will not be circumvented or that any failure of these measures will not have a material adverse effect on our ability to obtain and retain customers. Any of these factors could have a material adverse effect on our business and prospects. 11 <PAGE> Our failure to adequately protect our proprietary rights may adversely affect our business We rely on unpatented trade secrets and know-how to maintain our competitive position. Our inability to protect these secrets and know-how could have a material adverse effect on our business and prospects. We protect our proprietary information by entering into confidentiality agreements with employees and consultants and potential business partners. These agreements may be breached or terminated. In addition, third parties, including our competitors, may assert infringement claims against us. Any such claims, could result in costly litigation, divert management's attention and resources, and require us to pay damages and/or to enter into license or similar agreements under which we would be required to pay license fees or royalties. We may be exposed to liability for information carried over our network or displayed on web sites that we host Because we provide connections to the Internet and host web sites for our customers, we may be perceived as being associated with the content carried over our network or displayed on web sites that we host. We do not and cannot screen all of this content. As a result, we may face potential liability for defamation, negligence, copyright, patent or trademark infringement and other claims based on the content carried over our network or displayed on web sites that we host. These types of claims have been brought against providers of online services in the past and can be costly to defend regardless of the merit of the lawsuit. The protection offered by recent federal legislation that protects online services from some claims when the material is written by third parties is limited. Further, the law in this area remains in flux and varies from state to state. We may also suffer a loss of customers or reputational harm based on this content or resulting from our involvement in these legal proceedings. Our failure and the failure of third parties to be Year 2000 compliant could negatively impact our business Many currently installed computer systems and software products are coded to accept only two-digit entries in the date code field. The use of software and computer systems that are not Year 2000 compliant could result in system failures or miscalculations and may result in disruptions of operations including, among other things, a temporary inability to process transactions, send invoices or engage in normal business activities. We are subject to potential Year 2000 problems affecting our services and our business systems, the systems of the traditional local telephone companies and other vendors, and our customers' systems. Any of these Year 2000 problems could have a material adverse effect on our business, financial condition and results of operations. Year 2000 errors or defects may be discovered in our internal software or other systems and, if such errors or defects are discovered, the costs of making those systems Year 2000 compliant may be material. Year 2000 errors or defects in the internal systems maintained by the traditional local telephone companies and other vendors, could require us to incur significant unanticipated expenses to remedy any problems or, if possible, replace affected vendors. Furthermore, Year 2000 problems of our target customers could negatively impact their decision to buy our services. See "Management's Discussion and Analysis and Results of Operations--Impact of Year 2000." 12 <PAGE> Risks relating to ownership of our common stock Our stock price could fluctuate widely in response to various factors, many of which are beyond our control The trading price of our common stock has been and is likely to continue to be highly volatile. Our stock price could fluctuate widely in response to factors such as the following: . actual or anticipated variations in quarterly operating results; . announcements of new products or services by us or our competitors or new competing technologies; . the addition or loss of customers; . changes in financial estimates or recommendations by securities analysts; . conditions or trends in the telecommunications industry, including regulatory developments; . growth of the Internet and on-line commerce industries; . announcements by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments; . additions or departures of our key personnel; . future equity or debt offerings by us or our announcements of such offerings; and . general market and economic conditions. In addition, in recent years the stock market in general, and the Nasdaq National Market and the market for Internet and technology companies in particular, have experienced large price and volume fluctuations. These fluctuations have often been unrelated or disproportionate to the operating performance of these companies. These market and industry factors may materially and adversely affect our stock price, regardless of our operating performance. Our executive officers, directors and principal stockholders own a significant percentage of our company and will be able to exercise significant influence over our company, which could have a material and adverse effect on the market price of our common stock. After this offering, our executive officers, directors and principal stockholders and their affiliates will together control approximately 54.7% of our outstanding common stock. As a result, these stockholders, if they act together, will be able to control all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and will continue to have significant influence over our affairs. This concentration of ownership may have the effect of delaying, preventing or deterring a change in control, could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale and might affect the market price of our common stock. Certain provisions of our charter, by-laws and Delaware law make a takeover difficult Our corporate documents and Delaware law contain provisions that might enable our management to resist a takeover. These provisions include a staggered board of directors, limitations on persons authorized to call a special meeting of stockholders and advance notice procedures required for stockholders to make nominations of candidates for election as directors or to bring matters before an annual meeting of stockholders. These provisions might discourage, delay or prevent a change of control or a change in our management. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors and take other corporate actions. The existence of these provisions could limit the price that investors might be willing to pay in the future for shares of common stock and could deprive you of an opportunity to receive a premium for your common stock as part of a sale. 13 <PAGE> The market price of our common stock may drop significantly when the restrictions on resale by our existing securityholders lapse Following this offering, we will have approximately 63,382,196 shares of common stock outstanding. Approximately 50,156,196 shares, or 79%, of our outstanding common stock will be subject to restrictions on resale under U.S. securities laws. Holders of 2,371,144 shares have agreed not to sell these shares until April 4, 2000, and holders of 37,380,293 shares have agreed not to sell these shares for at least 90 days following the date of this prospectus, in each case without the consent of Deutsche Bank Securities Inc. As these restrictions on resale end beginning in April 2000, the market price of our common stock could drop significantly if holders of these shares sell them or are perceived by the market as intending to sell them. These sales also may make it difficult for us to sell equity securities in the future at a time and price that we deem appropriate. See "Shares Eligible for Future Sale." We will have discretion as to the use of the proceeds of this offering, which we may not use effectively We have not committed the net proceeds of this offering to any particular purpose. As a result, our management will have significant flexibility in applying the net proceeds of this offering and could apply them in ways with which stockholders may disagree. If we do not apply the funds we receive effectively, our accumulated deficit will increase and we may lose significant business opportunities. See "Use of Proceeds." Investors will experience immediate and substantial dilution in the book value of their investment If you purchase shares of our common stock in this offering, you will experience immediate and substantial dilution because the price you pay will be substantially greater than the net tangible book value per share of the shares you acquire. This dilution is due, in large part, to the fact that certain of our current investors paid substantially less than the public offering price when they purchased their shares of common stock. You will experience additional dilution upon the exercise of outstanding stock options and warrants to purchase common stock. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS AND CERTAIN OTHER INFORMATION Some of the statements under "Prospectus Summary," "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations," and "Business," on the inside front cover and elsewhere in this prospectus constitute forward-looking statements. These statements relate to future events or our future financial or business performance and are identified by terminology such as "may," "might," "will," "should," "expect," "scheduled," "plan," "intend," "anticipate," "believe," "estimate," "potential," or "continue" or the negative of such terms or other comparable terminology. Actual events or results may differ materially. In evaluating these statements, you should specifically consider various factors, including the risks outlined under "Risk Factors." These factors, among others, may cause our actual results to differ materially from any forward-looking statement. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We use market data and industry forecasts throughout this prospectus, which we have obtained from internal surveys, market research, publicly available information and industry publications. We believe that the surveys and market research we or others have performed is reliable, but we have not independently verified this information. Such information may not be accurate. 14 <PAGE>

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+RISK FACTORS YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS BEFORE YOU DECIDE TO BUY OUR CLASS A COMMON STOCK. YOU SHOULD ALSO CONSIDER THE OTHER INFORMATION IN THIS PROSPECTUS. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCUR, OUR BUSINESS, FINANCIAL CONDITION, OPERATING RESULTS OR CASH FLOWS COULD BE MATERIALLY ADVERSELY AFFECTED. THIS COULD CAUSE THE TRADING PRICE OF OUR CLASS A COMMON STOCK TO DECLINE, AND YOU MAY LOSE PART OR ALL OF YOUR INVESTMENT. THE GROWTH AND PROFITABILITY OF OUR BUSINESS COULD BE LIMITED IF WE ARE UNABLE TO EXPAND IN A TIMELY AND PROFITABLE MANNER To continue to grow, we and our franchisees must open new restaurants on a timely and profitable basis. We have experienced delays in restaurant openings from time to time and may experience delays in the future. Delays or failures in opening new restaurants could limit the growth of our business and profitability. We opened 29 company owned or operated restaurants in fiscal 1999 and our franchisees opened 62 restaurants. To date in fiscal 2000 we have opened three company owned restaurants and our worldwide franchise community has opened 14 restaurants. During the remainder of 2000 we plan to open 34 additional restaurants and our franchisees plan on opening approximately 40 additional restaurants. Our ability to expand successfully will depend on a number of factors, some of which are beyond our control, including: - identification and availability of suitable restaurant sites; - competition for restaurant sites; - negotiation of favorable leases; - timely development in certain cases of commercial, residential, street or highway construction near our restaurants; - management of construction and development costs of new restaurants; - securing required governmental approvals and permits; - recruitment of qualified operating personnel, particularly culinary experts and restaurant managers; - competition in new markets; and - general economic conditions. In addition, we contemplate entering new markets, including international markets and nontraditional locations, in which we have no or limited operating experience. These new markets may have different demographic characteristics, competitive conditions, consumer tastes and discretionary spending patterns than our existing markets, which may cause our new restaurants to be less successful in these markets than in our existing markets. DIFFICULTIES IN OUR FRANCHISE OPERATIONS MAY LIMIT OUR GROWTH AND INCREASE THE COSTS OF OPERATING OUR FRANCHISING PROGRAM Our success is dependent, in part, on the development and growth of our franchising program. There can be no assurance that we will continue to successfully locate and attract suitable franchisees or that our franchisees will have the business abilities or sufficient access to capital to open restaurants or operate restaurants in a manner consistent with our concepts and standards. The success of our franchising program will depend on factors such as identifying the availability of suitable sites on acceptable lease or purchase terms, obtaining necessary approvals and permits and adapting to changing economic and business conditions. If a significant number of our franchisees stop participating in purchases from the national distribution companies that are the primary suppliers of our food, our ability to negotiate favorable terms with these suppliers could be weakened. See "Business-Our Franchise System." We are also subject to a substantial number of state and foreign laws regulating the offer and sale of franchises. These laws impose registration and disclosure requirements on franchisors in the offer and sale of franchises and may also regulate termination, renewal fees and other substantive aspects of our relationship with our franchisees. We are subject to Federal Trade Commission regulations governing disclosure requirements in the sale of franchises. We believe that we are in compliance with applicable laws and regulations governing our operations. OUR INTERNATIONAL FRANCHISE OPERATIONS ARE SUBJECT TO SOCIAL, POLITICAL AND ECONOMIC RISKS In fiscal 1999, approximately 1.8% of our net revenues came from franchise royalties, franchise fees and concept fees paid by our international franchisees. Social, economic and political conditions in these international markets may adversely affect the profitability of our international franchisees and restrict their ability to pay these fees, which could reduce our revenues. The overall risks to our international franchisees include changes in foreign governmental policies, and other political or economic developments. These developments may lead to new pricing, tax or other policies and monetary fluctuations which may result in increased costs to our international franchisees. Continuing economic turmoil in Asia has slowed the expansion of our franchising program in this region and the growth of revenues and cash flows with respect to our franchisees' restaurants in Asia. OUR IMPLEMENTATION OF NEW BUSINESS CONCEPTS AND STRATEGIES MAY NOT BE SUCCESSFUL We continue to initiate new business concepts and strategies, including the development of new restaurant concepts, the introduction of new menu items and the development of international and nontraditional locations. We have limited experience in the development, operation and franchising of restaurant concepts other than T.G.I. Friday's. There can be no assurance that we will continue to develop new concepts and strategies, that such concepts and strategies will be successful or profitable or that such concepts and strategies will fill the strategic roles we intend. FLUCTUATIONS IN OUR OPERATING RESULTS MAY RESULT IN DECREASES IN OUR STOCK PRICE Our operating results may fluctuate significantly due to several factors, including the timing of new restaurant openings and related expenses, profitability of new restaurants, increases or decreases in comparable restaurant sales, interest rates, general economic conditions, consumer confidence in the economy, changes in consumer preferences, competitive factors and weather conditions. As a result, our operating results and profitability may fall below the expectations of public market analysts and investors. In that event, the price of our Class A common stock would likely decrease. In the past, our preopening costs have varied significantly from quarter to quarter primarily due to the timing of restaurant openings. We typically incur most preopening costs for a new restaurant within the two months immediately preceding, and the month of, its opening. In addition, our labor and operating costs for a newly opened restaurant during the first three to six months of operation are materially greater than what can be expected after that time, both in aggregate dollars and as a percentage of restaurant sales. Accordingly, the volume and timing of new restaurant openings in any quarter has had and is expected to continue to have a significant impact on quarterly preopening costs, labor and direct costs. Due to these factors, results for a quarter may not be indicative of results to be expected for any other quarter or for a full fiscal year. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of our historical operating results. WE COULD FACE LABOR SHORTAGES THAT MAY IMPAIR OUR ABILITY TO OPEN NEW STORES AND PROVIDE QUALITY SERVICE Our success depends in part upon our ability to attract, motivate and retain a sufficient number of qualified employees, including restaurant managers, kitchen staff and wait staff, necessary to meet our expansion schedule. Qualified individuals needed to fill these positions are in short supply in certain areas, and the inability to recruit and retain such individuals may delay the planned openings of new restaurants or result in high employee turnover in existing restaurants which could limit our ability to expand our operations and provide quality customer service. Additionally, competition for qualified employees could require us to pay higher wages to attract sufficient employees, which could result in higher labor costs. CHANGES IN CONSUMER PREFERENCES OR DISCRETIONARY CONSUMER SPENDING COULD REDUCE OUR REVENUES AND CASH FLOWS Most of our restaurants feature full-service food and beverage selections served in a casual dining atmosphere. Our continued success depends, in part, upon the popularity of our menu items and this style of casual dining. Shifts in consumer preferences away from our cuisine or dining style could result in lower revenues and cash flows. Also, our success depends to a significant extent on numerous factors affecting discretionary consumer spending, including economic conditions, disposable consumer income and consumer confidence. Adverse changes in these factors could reduce guest visits or impose practical limits on pricing, either of which could reduce our revenues and cash flows. OUR OPERATIONS DEPEND ON GOVERNMENTAL LICENSES AND WE MAY FACE LIABILITY UNDER "DRAM SHOP" STATUTES WHICH MAY RESULT IN SIGNIFICANT COSTS TO US Our business depends on obtaining and maintaining required food service and liquor licenses for each of our restaurants. If we fail to hold all necessary licenses, we may be forced to delay or cancel new restaurant openings and close or reduce operations at existing locations. In addition, our sale of alcoholic beverages subjects us to "dram shop" statutes in most states. These statutes allow an injured person to recover damages from an establishment that served alcoholic beverages to an intoxicated person who caused the injury. If we receive a judgment substantially in excess of our insurance coverage, or if we fail to maintain our insurance coverage, we may be required to make unanticipated payments that could decrease our profitability. See "Business-Government Regulations" for a discussion of the regulations we must comply with. COMPLAINTS OR LITIGATION FROM GUESTS MAY HARM OUR REPUTATION AND REDUCE OUR REVENUES We are, from time to time, the subject of complaints or litigation from guests alleging illness, injury or other food quality, health or operational concerns. Adverse publicity resulting from these allegations may harm our restaurants' reputation and reduce our revenues, regardless of whether the allegations are valid or whether we are liable. These claims may divert our financial and management resources that would otherwise be used to benefit the future performance of our operations. Our reputation may be adversely affected by publicity relating to restaurants operated by our franchisees. We have less ability to assure compliance with our standards at our franchised restaurants than we do at our company owned or operated restaurants. LOSS OF OUR PRIMARY SUPPLIERS OR INCREASED FOOD COSTS COULD IMPAIR OUR PROFITABILITY Our profitability depends in part on our ability to anticipate and react to changes in food costs. On January 31, 2000, our primary distributor of food and supply items filed Chapter 11 bankruptcy under the U.S. Bankruptcy Code. We recently transitioned from this one national distribution company to three distribution companies as the primary domestic suppliers of our food and other restaurant supplies. This transition resulted in increased food and supply cost. Although we believe that alternative sources of supply are available, any increase in prices or failure to perform by these national distribution companies could cause our food costs to increase. Furthermore, various factors beyond our control, including adverse weather conditions and governmental regulation, may affect our food costs. We cannot predict whether we will be able to effectively anticipate and react to changing food costs by adjusting our purchasing practices and menu prices, and a failure to do so could decrease our profitability and our cash flows. OUR LIMITED CASH RESERVES AND INCREASED DEBT OBLIGATIONS MAY IMPAIR OUR ABILITY TO GROW OUR BUSINESS AND RESPOND TO CHANGING CONDITIONS As a result of the $175.0 million dividend paid to Carlson Companies in mid-1999, we have substantially no equity and increased debt obligations. The net proceeds of this offering will be used to partially repay intercompany indebtedness to Carlson Companies, including amounts outstanding under the promissory note issued in partial payment of the dividend. Accordingly, after this offering and application of the proceeds of this offering to reduce our intercompany indebtedness, we will have limited cash reserves and will be dependant upon cash generated from operations and external financing in order to grow our business and respond to changing conditions. OUR EXISTING STOCKHOLDER WILL RETAIN SIGNIFICANT CONTROL WHICH COULD DEPRESS THE PRICE OF YOUR SHARES Upon completion of this offering, our existing stockholder, Carlson Companies, will own 100.0% of our outstanding Class B common stock. The shares of Class B common stock are entitled to 10 votes per share on all matters submitted to a vote of stockholders and the shares of Class A common stock are entitled to one vote per share on all matters submitted to a vote of stockholders. As a result, Carlson Companies will own approximately 95.1% of our total voting power and will be able to control us and direct our affairs, including the election of directors and approval of significant corporate transactions. In addition, we are reliant upon Carlson Companies for various corporate functions that they provide to us on a fee basis, such as purchasing, accounting and insurance, that may make it difficult for another company to acquire us. This concentration of ownership also may delay, defer or prevent a change in our control, and make some transactions more difficult or impossible without Carlson Companies' support. These transactions might include proxy contests, mergers, tender offers, open market purchase programs or other purchases of Class A common stock that could give our stockholders the opportunity to realize a premium over the then prevailing market price for shares of Class A common stock. See "Principal Stockholders" for information about Carlson Companies and the number of shares it will control. CHANGES IN OUR RELATIONSHIP WITH CARLSON COMPANIES COULD REQUIRE US TO NEGOTIATE ALTERNATE AGREEMENTS WHICH MAY HAVE LESS FAVORABLE TERMS After this offering, we will continue to obtain various services from Carlson Companies under a shared services agreement. The services provided by Carlson Companies under this agreement are material to our operations. These services include obtaining supplies and providing insurance, accounting services, human resources information services, benefits administration, transaction processing services, various tax and treasury services and information technology maintenance and systems development. The intention of this agreement is to continue the relationship between us and Carlson Companies in a manner consistent with past practices. If the shared services agreement is terminated, we will have to obtain the services covered by the agreement on our own. We may not be able to replace all of these services in a timely manner or on terms, including cost, that are as favorable as those we receive from Carlson Companies. CARLSON COMPANIES' POSITION AS OUR CONTROLLING STOCKHOLDER MAY RESULT IN UNFAVORABLE AND COSTLY TERMS IN OUR ARRANGEMENTS WITH THEM Carlson Companies' position as our controlling stockholder may cause conflicts of interest to arise over the nature, quality and pricing of services or products provided to us by Carlson Companies or by us to Carlson Companies under the shared services agreement or other agreements. Furthermore, because we are currently a wholly-owned subsidiary of Carlson Companies, none of our agreements with Carlson Companies resulted from arm's-length negotiations and, therefore, the prices we are charged for services provided by Carlson Companies may be higher or lower than prices that would be charged to third parties. For more information about these agreements, see "Relationship with Carlson Companies and Related Transactions." OUR PARTICIPATION IN CARLSON COMPANIES' CASH MANAGEMENT PROGRAM AND CARLSON COMPANIES' POSITION AS OUR PRIMARY LENDER COULD RESTRICT OUR ACCESS TO CASH As a part of our ongoing relationship with Carlson Companies, we participate in its cash management program. Carlson Companies is our primary lender and source of working capital. We have entered into a credit agreement with Carlson Companies which covers all of our outstanding indebtedness to them and our ongoing cash requirements. Our ability to borrow funds to finance our operations is subject to Carlson Companies' ability to raise working capital and draw on its own line of credit. Any impairment of Carlson Companies' ability to lend us funds could impair our ability to satisfy our cash needs or limit our ability to fund our planned capital expenditures. We deliver all of our excess cash to Carlson Companies for inclusion in its cash management program. While we are a debtor of Carlson Companies, this cash will be used to pay down our intercompany indebtedness to them. Our intercompany cash management account with Carlson Companies is an interest-earning asset or an interest-bearing liability depending on the level of cash receipts and disbursements. When our cash account with Carlson Companies is positive, we are a general creditor of Carlson Companies with respect to such funds and our rights to these funds are subject to Carlson Companies' financial condition and the rights of other creditors. As a result, our rights to these funds may be adversely affected by any financial difficulties or insolvency experienced by Carlson Companies. WE HAVE HISTORICALLY BEEN A MEMBER OF A CONSOLIDATED TAX GROUP WITH CARLSON COMPANIES WHICH COULD LEAD TO LIABILITY FOR US Prior to the completion of this offering, we and Carlson Companies are part of a consolidated group for tax purposes. As a result, we are jointly and severally liable with Carlson Companies for all tax liabilities incurred and payable by any member of the Carlson Companies consolidated tax group. Upon consummation of this offering we will no longer be a part of this consolidated tax group for federal income tax purposes and we will no longer be part of a combined tax group for purposes of taxation in a few states. However, we will remain jointly and severally liable with Carlson Companies for all tax liabilities relating to prior periods. In addition, we will continue to be part of a combined tax group with Carlson Companies for purposes of taxation by some states. Our tax sharing agreement with Carlson Companies allows Carlson Companies to control our tax decisions with respect to periods and returns for which we are part of a consolidated or combined tax group. As a result, Carlson Companies may be able to make decisions in its collective best interest that may not be in our best interest. FIVE OF OUR DIRECTORS MAY HAVE CONFLICTS OF INTEREST BECAUSE THEY ARE ALSO CARLSON COMPANIES DIRECTORS OR OFFICERS Five of our directors are also directors or officers of Carlson Companies, which may create conflicts of interest when our board of directors faces decisions that affect both us and Carlson Companies. YOU MAY NOT BE ABLE TO RESELL THE CLASS A COMMON STOCK YOU BUY AT OR ABOVE THE INITIAL PUBLIC OFFERING PRICE We do not know the level of trading volume that will exist for our Class A common stock after the offering. Trading volume levels may affect your ability to sell your shares quickly at the current market price. If trading volume levels are low, the limited demand from buyers may cause delays in selling your shares at the then current market price or impair your ability to sell your shares at a price equal to or greater than the price you paid. Because the initial public offering price of our Class A common stock has been determined by our negotiations with the underwriters, it is not necessarily indicative of the market price that will develop for our Class A common stock, which may be higher or lower than the price you pay. FUTURE SALES OF OUR COMMON STOCK MAY DEPRESS OUR STOCK PRICE AND LIMIT OUR ABILITY TO RAISE CAPITAL IN THE MARKET Sales of substantial amounts of our stock in the public market, or the perception that these sales may occur, could adversely affect the market price of our stock and our ability to raise capital through a public offering of our equity securities. After this offering, the shares offered under this prospectus will be freely tradeable. The 18,500,000 outstanding shares of our Class B common stock may be sold after their 180-day lock-up period, subject to the restrictions of Rule 144 under the Securities Act of 1933. See "Shares Eligible for Future Sale" for a discussion of potential future sales of our common stock. PROVISIONS OF OUR CERTIFICATE OF INCORPORATION, OUR BYLAWS AND DELAWARE LAW COULD DISCOURAGE POTENTIAL ACQUISITION PROPOSALS AND DELAY OR PREVENT A CHANGE IN CONTROL Our certificate of incorporation will authorize the board of directors to issue up to 10,000,000 shares of preferred stock and to determine the powers, preferences, privileges, rights, including voting rights, qualifications, limitations and restrictions of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The charter and bylaws, among other things, require that stockholder actions occur at duly called meetings of the stockholders, limit who may call special meetings of stockholders, do not permit cumulative voting in the special meetings of stockholders, do not permit cumulative voting in the election of directors and require advance notice of stockholder proposals and director nominations. Also, Section 203 of the Delaware General Corporation Law restricts certain business combinations with any "interested stockholder" as defined by the statute. These and other provisions could have the effect of making it more difficult for a third party to acquire a majority of outstanding voting stock, discourage a hostile bid or delay, prevent or deter a merger, acquisition or tender offer in which our stockholders could receive a premium for their shares, or a proxy contest for control of the company or other changes in our management. See "Description of Capital Stock."

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+RISK FACTORS An investment in our ADSs or ordinary shares involves a high degree of risk. You should carefully consider the following information about these risks, together with the other information contained in this document, including our consolidated financial statements and related notes, before you decide to buy our ADSs or ordinary shares. If any of the following risks actually occur, our business, results of operations and financial condition would likely suffer. In any such case, the market price of our ADSs or ordinary shares could decline, and you may lose all or part of the money you paid to buy our ADSs or ordinary shares. RISKS RELATED TO OUR FINANCIAL CONDITION WE HAVE A HISTORY OF LOSSES AND NEGATIVE CASH FLOWS AND THIS MAY CONTINUE. Since our inception in 1987, we have incurred significant operating losses and negative cash flows. This was true even in years in which our revenues increased. For example, in 1998, revenue increased 11.3% over 1997 but operating losses were 103.9% higher. The increase in revenue in 1998 was driven by higher shipment volumes but was offset by a 12.0% decline from 1997 in our average selling price of silicon wafers, higher production costs on increased volume and under utilization of capacity at our fabrication facilities. As of December 31, 1999, we had a retained deficit of approximately $277.7 million. We cannot assure you that our operating losses or negative cash flows will not continue or increase in the future or that we will become profitable. Please see "Selected Financial Data" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" for information regarding our financial condition. WE NEED TO CONTINUOUSLY IMPROVE OUR DEVICE YIELDS, MAINTAIN HIGH CAPACITY UTILIZATION AND OPTIMIZE THE TECHNOLOGY MIX OF OUR SILICON WAFER PRODUCTION TO ACHIEVE OUR PROFIT TARGETS. The key factors that affect our profit margin are our ability to: - continuously improve our device yields; - maintain high capacity utilization; and - optimize the technology mix of our silicon wafer production. The term "device yields" means the actual number of usable semiconductor devices on a wafer in relation to the total number of devices on the wafer. Our device yields directly affect our ability to attract and retain customers, as well as the price of our services. The term "capacity utilization" means the actual number of silicon wafers we are processing at a fabrication facility, or fab, in relation to the total number of wafers we have the capacity to process. Our capacity utilization affects our operating results because a large percentage of our operating costs are fixed. For example, in 1996, 1997 and 1998, a worldwide overcapacity of semiconductor wafer supply resulted in lower utilization rates at our fabs. This had a negative effect on our company during such period. Other factors potentially affecting capacity utilization rates are the complexity and mix of the wafers produced, overall industry conditions, operating efficiencies, the level of customer orders, mechanical failure, disruption of operations due to expansion of operations or relocation of equipment and fire or natural disaster. Because the price of wafers varies significantly, the mix of wafers produced affects revenue and profitability. The value of a wafer is determined by the complexity of the device on the wafer. Production of devices with higher level functionality and greater system-level integration requires more manufacturing steps than the production of less complex devices and commands higher wafer prices. If we are unable to continuously improve our device yields, maintain high capacity utilization or optimize the technology mix of our wafer production, we may not be able to achieve our profit targets in which case the market price of our ADSs or ordinary shares could fall. OUR OPERATING RESULTS FLUCTUATE FROM QUARTER-TO-QUARTER WHICH MAKES IT DIFFICULT TO PREDICT OUR FUTURE PERFORMANCE. Our revenues, expenses and operating results have varied significantly in the past and may fluctuate significantly from quarter-to-quarter in the future due to a number of factors, many of which are outside our control. These factors include, among others: - the cyclical nature of both the semiconductor industry and the markets served by our customers; - shifts by integrated device manufacturers, or IDMs, between internal and outsourced production; - our customers' adjustments in their inventory; - the loss of a key customer or the postponement of an order from a key customer; - the rescheduling and cancellation of large orders; - the timing and volume of orders relative to our available production capacity; - our ability to obtain raw materials and equipment on a timely and economic basis; - environmental events or industrial accidents such as fires; - currency and interest rate fluctuations that may not be adequately hedged; and - technological changes. Due to the factors noted above and other risks discussed in this section, many of which are beyond our control, you should not rely on quarter-to-quarter comparisons to predict our future performance. Unfavorable changes in any of the above factors may seriously harm our company. In addition, it is possible that in some future periods our operating results may be below the expectations of public market analysts and investors. In this event, the price of our ADSs or ordinary shares may underperform or fall. WE EXPECT TO INCUR SUBSTANTIAL CAPITAL EXPENDITURES IN CONNECTION WITH OUR GROWTH PLANS AND MAY REQUIRE ADDITIONAL FINANCING THAT MAY NOT BE AVAILABLE. Our business and the nature of our industry require us to make substantial capital expenditures leading to a high level of fixed costs. We expect to incur significant capital expenditures in connection with our growth plans. For example, in February 2000, we commenced construction of Fab 7 and expect to require additional financing to complete its construction and equipping. We are also currently expanding and adding additional equipment to increase the capacity of our fabs, two of which are jointly-owned with third parties, and expect to require additional financing to complete such equipping. These capital expenditures will be made in advance of sales. Given the fixed cost nature of our business, we may incur operating losses if our revenue does not adequately offset the level of our capital expenditures, as occurred in 1997, 1998 and the first three quarters of 1999. Additionally, our actual expenditures may exceed our planned expenditures for a variety of reasons, including changes in our growth plan, our process technology, market conditions, interest rates and other factors. CSP, our strategic alliance that owns and will operate Fab 6, intends to enter into a credit facility providing for borrowings of approximately $820 million to finance its capital expenditure requirements, including approximately $480 million for its planned capital expenditures for 2000. The actual amount of debt to be incurred under the facility will be influenced by several factors, including without limitation, the speed and timing of the ramp up of operations at Fab 6 and the terms of such debt. We will require additional financing to fund our current growth plan. There can be no assurance that additional financing will be available at all or, if available, that such financing will be obtained on terms favorable to us or that any additional financing will not be dilutive to our shareholders. In addition, a substantial portion of our borrowings is guaranteed by our controlling shareholder, ST, and its affiliates. We may not be able to obtain similar credit guarantees from ST in the future. WE HAVE A HIGH LEVEL OF DEBT. IF WE ARE UNABLE TO MAKE INTEREST AND PRINCIPAL PAYMENTS ON OUR DEBT, IT COULD SERIOUSLY HARM OUR COMPANY. We have now and will continue to have a significant amount of debt. Our high level of debt and the covenants contained in our financing documents could have important consequences to you. For example, they could: - increase our vulnerability to general adverse economic and industry conditions; - limit our ability to pursue our growth plan; - require us to seek the lender's consent prior to paying dividends on our ordinary shares; - require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing the availability of our cash flow to fund capital expenditures, working capital and other general corporate purposes; and - limit our flexibility in planning for, or reacting to, changes in our business and the semiconductor industry. We cannot assure you that we will be able to make interest and principal payments on debt incurred in connection with our growth if the average selling prices or demand for our semiconductor wafers are lower than expected. RISKS RELATED TO OUR OPERATIONS THE CYCLICAL NATURE OF THE SEMICONDUCTOR INDUSTRY AND THE PERIODIC OVERCAPACITY THAT RESULTS FROM THIS MAY SERIOUSLY HARM OUR COMPANY. The semiconductor industry has historically been highly cyclical and, at various times, has experienced significant economic downturns characterized by production overcapacity, reduced product demand, and rapid erosion of average selling prices. Historically, companies in the semiconductor industry have expanded aggressively during periods of increased demand, as we and our competitors are doing currently. As a result, periods of overcapacity in the semiconductor industry have frequently followed periods of increased demand. We expect this pattern to be repeated in the future. In addition, the markets for semiconductors are characterized by rapid technological change, evolving industry standards, intense competition and fluctuations in end-user demand. Our operating results for 1997 and 1998 were seriously harmed by a downturn in the semiconductor market. Future downturns in the semiconductor industry may be severe and could seriously harm our company. A DECREASE IN DEMAND FOR COMMUNICATIONS EQUIPMENT AND PERSONAL COMPUTERS MAY SIGNIFICANTLY DECREASE THE DEMAND FOR OUR SERVICES. A significant percentage of our sales revenue is derived from customers who use our manufacturing services to make semiconductors for communications equipment and personal computers. Any significant decrease in the demand for communications equipment or personal computers may decrease the demand for our services and could seriously harm our company. In addition, the declining average selling price of communications equipment and personal computers places significant pressure on the prices of the components that are used in this equipment. If the average selling prices of communications equipment and personal computers continue to decrease, the pricing pressure on components produced by our company may reduce our revenue and therefore reduce our gross profit margin significantly. WE DEPEND ON A SMALL NUMBER OF CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR REVENUES. We have been largely dependent on a small number of customers for a substantial portion of our business. Our top ten customers accounted for 62.8% and 62.3% of our total net revenue in 1998 and 1999, respectively. In 1998, our two largest customers accounted for approximately 9.6% and 9.3% of our total net revenue, respectively, and, in 1999, our two largest customers accounted for 11.1% and 7.4% of our total net revenue, respectively. We expect that we will continue to be dependent upon a relatively limited number of customers for a significant portion of our revenue. We cannot assure you that revenue generated from these customers, individually or in the aggregate, will reach or exceed historical levels in any future period. Loss or cancellation of business from, significant changes in scheduled deliveries to, or decreases in the prices of services sold to, any of these customers could seriously harm our company. Please see "Business -- Customers and Markets" for additional information regarding our customers. OUR CUSTOMERS DO NOT PLACE PURCHASE ORDERS FAR IN ADVANCE. THEREFORE, WE DO NOT HAVE ANY SIGNIFICANT BACKLOG. Our customers generally do not place purchase orders far in advance. In addition, due to the cyclical nature of the semiconductor industry, our customers' purchase orders have varied significantly from period-to-period. As a result, we do not typically operate with any significant backlog. The lack of a significant backlog makes it difficult for us to forecast our net revenue in future periods. Moreover, our expense levels are based in part on our expectations of future revenue and we may be unable to adjust costs in a timely manner to compensate for revenue shortfalls. We expect that in the future our revenue in any quarter will continue to be substantially dependent upon purchase orders received in that quarter. We cannot assure you that any of our customers will continue to place orders with us in the future at the same levels as in prior periods. WE MAY NOT BE ABLE TO IMPLEMENT NEW TECHNOLOGY AS IT BECOMES AVAILABLE WHICH MAY AFFECT OUR ABILITY TO PRODUCE ADVANCED PRODUCTS AT COMPETITIVE PRICES. The semiconductor industry is rapidly developing and the technology used is constantly evolving. If we do not anticipate the technology evolution and rapidly adopt new and innovative technology, we may not be able to produce sufficiently advanced products at competitive prices. There is a risk that our competitors may adopt new technology before we do, resulting in our loss of market share. If we do not continue to produce the most advanced products at competitive prices, our customers may use the services of our competitors instead of our services, which could seriously harm our company. WE DEPEND ON OUR TECHNOLOGY PARTNERS TO ADVANCE OUR PORTFOLIO OF PROCESS TECHNOLOGIES. Enhancing our manufacturing process technologies is critical to our ability to provide services for our customers. We intend to continue to advance our process technologies through internal research and development efforts and technology alliances with leading semiconductor suppliers. Although we have an internal research and development team focused on developing new semiconductor manufacturing process technologies, we are dependent on our technology partners to advance our portfolio of process technologies. We currently have joint development and technology sharing agreements with Lucent and Agilent Technologies, a subsidiary of Hewlett-Packard, a technology transfer and licensing agreement with Motorola and a joint development agreement with Ericsson Microelectronics AB, or Ericsson. If we are unable to continue our technology alliances with Lucent, Agilent Technologies and Motorola on mutually beneficial economic terms, or are unable to enter into new technology alliances with other leading semiconductor suppliers, we may not be able to continue providing our customers with leading edge process technologies, which could seriously harm our company. Please see "Business -- Research and Development" for additional information regarding our internal research and development efforts. WE DEPEND ON OUR STRATEGIC ALLIANCES RELATING TO FAB 5 AND FAB 6. TERMINATION OF EITHER OF THESE ALLIANCES COULD SERIOUSLY HARM OUR COMPANY. We currently have two strategic alliances relating to the development and operation of Fab 5 and Fab 6. Silicon Manufacturing Partners, or SMP, which operates Fab 5, is jointly-owned with a subsidiary of Lucent. CSP, which owns and will operate Fab 6, is jointly-owned with EDB Investments Pte Ltd and a subsidiary of Agilent Technologies. We believe our alliances with these companies give us access to select leading edge process technologies, moderate our development costs and capital expenditures and increase our fab utilization rates. The termination of either of these alliances could seriously harm our company. Please see "Business -- Chartered Silicon Partners" and "-- Silicon Manufacturing Partners" for a more detailed description of these alliances and for certain recent developments regarding Hewlett-Packard. WE MAY NOT BE ABLE TO COMPETE SUCCESSFULLY IN OUR INDUSTRY. The worldwide semiconductor foundry industry is highly competitive. We compete with dedicated foundry service providers such as Taiwan Semiconductor Manufacturing Corporation, or TSMC, and United Microelectronics, or UMC, as well as the foundry operation services of some IDMs such as International Business Machines, or IBM. IDMs principally manufacture and sell their own proprietary semiconductor products, but may offer foundry services. Our competitors may have greater access to capital and substantially greater production, research and development, marketing and other resources than we do. As a result, these companies may be able to compete more aggressively over a longer period of time than we can. A number of semiconductor manufacturers, including our primary competitors and our company, have recently announced plans to increase their manufacturing capacity and, as a result, we expect that there will be a significant increase in worldwide semiconductor capacity over the next five years. If growth in demand for this capacity fails to match the growth in supply, or occurs more slowly than anticipated, there may be more intense competition and pressure on the pricing of our services may result. Any significant increase in competition may erode our profit margins and weaken our earnings. The principal elements of competition in the wafer foundry market include technical competence, time-to-market, research and development quality, available capacity, device yields, customer service and price. We cannot assure you that we will be able to compete successfully in the future, which could seriously harm our company. OUR BUSINESS DEPENDS IN PART ON OUR ABILITY TO OBTAIN AND PRESERVE INTELLECTUAL PROPERTY RIGHTS. Our ability to compete successfully and achieve future growth will depend, in part, on our ability to protect our proprietary technology. As of December 31, 1999, we held 179 patents worldwide, 141 of which are U.S. patents, related to our production processes. We intend to continue to file patent applications when appropriate to protect our proprietary technologies. The process of seeking patent protection may take a long time and be expensive. We cannot assure you that patents will be issued from pending or future applications or that, if patents are issued, they will not be challenged, invalidated or circumvented or that the rights granted under the patents will provide us with meaningful protection or any commercial advantage. In addition, we cannot assure you that the Asian countries in which we market our services, such as Taiwan and China, will protect our intellectual property rights to the same extent as the United States. Please see "Business -- Intellectual Property" for a more detailed description of our proprietary technology. WE MAY BE SUBJECT TO INTELLECTUAL PROPERTY RIGHTS DISPUTES. Our ability to compete successfully depends on our ability to operate without infringing the proprietary rights of others. We have no means of knowing what patent applications have been filed in the United States until they are granted. Although we are not currently a party to any material litigation involving patent infringement, the semiconductor industry is characterized by frequent litigation regarding patent and other intellectual property rights. As is typical in the semiconductor industry, we have from time to time received communications from third parties asserting patents that cover certain of our technologies and alleging infringement of certain intellectual property rights of others. We expect to receive similar communications in the future. In the event any third party were to make a valid claim against us or our customers we could be required to: - discontinue using certain process technologies which could cause us to stop manufacturing certain semiconductors; - pay substantial monetary damages; - seek to develop non-infringing technologies, which may not be feasible; or - seek to acquire licenses to the infringed technology which may not be available on commercially reasonable terms, if at all. Our company could be seriously harmed by such developments. Litigation, which could result in substantial costs to us and diversion of our resources, may also be necessary to enforce our patents or other intellectual property rights or to defend us against claimed infringement of the rights of others. If we fail to obtain necessary licenses or if litigation relating to patent infringement or other intellectual property matters occurs, it could seriously harm our company. RISKS RELATING TO MANUFACTURING WE MAY EXPERIENCE DIFFICULTY IN ACHIEVING ACCEPTABLE DEVICE YIELDS, PRODUCT PERFORMANCE AND DELIVERY TIMES AS A RESULT OF MANUFACTURING PROBLEMS. The process technology for the manufacture of semiconductor wafers is highly complex, requires advanced and costly equipment and is continuously being modified in an effort to improve device yields and product performance. Microscopic impurities such as dust and other contaminants, difficulties in the production process, disruptions in the supply of utilities or defects in the key materials and tools used to manufacture a particular wafer can cause a percentage of the wafers to be rejected or individual semiconductors on specific wafers to be non-functional, which in each case negatively affects our device yields. We have, from time to time, experienced production difficulties that have caused delivery delays, lower than expected device yields and the replacement of certain vendors of manufacturing equipment used in our production processes. We may also experience difficulty achieving acceptable device yields, product performance and product delivery times in the future as a result of manufacturing problems. These problems may result from, among other things, capacity constraints, construction delays, increasing production at new facilities, upgrading or expanding existing facilities or changing our process technologies. Any of these problems could seriously harm our company. WE DEPEND ON OUR SUPPLIERS OF RAW MATERIALS AND EQUIPMENT AND DO NOT TYPICALLY HAVE LONG-TERM SUPPLY CONTRACTS WITH THEM. We depend on our suppliers of raw materials. To maintain competitive manufacturing operations, we must obtain from our suppliers, in a timely manner, sufficient quantities of quality materials at acceptable prices. We obtain most of our materials, including critical materials such as raw silicon wafers, from a limited number of suppliers. We purchase all of our materials on a blanket purchase order basis. With the exception of one multi-year contract for the purchase of raw wafers, we do not have long-term contracts with any of our suppliers. From time to time, vendors have extended lead times or limited the supply of required materials to us because of capacity constraints. Consequently, from time to time, we have experienced difficulty obtaining quantities of raw materials we need on a timely basis. In addition, from time to time, we may reject materials that do not meet our specifications, resulting in declines in output or device yields. We cannot assure you that we will be able to obtain sufficient quantities of raw materials and other supplies of an acceptable quality. If our ability to obtain sufficient quantities of raw materials and other supplies in a timely manner is substantially diminished or if there are significant increases in the costs of raw materials, it could seriously harm our company. We also depend on a limited number of manufacturers and vendors that make and sell the complex equipment we use in our manufacturing processes. In periods of high market demand which the industry is currently facing, the lead times from order to delivery of this equipment could be as long as 12 to 18 months. If there are delays in the delivery of this equipment or if there are increases in the cost of this equipment, it could seriously harm our company. Please see "Business -- Equipment and Materials" for additional information regarding our relationships with our suppliers of materials and equipment. WE DEPEND ON ST ASSEMBLY TEST SERVICES LTD FOR MOST OF OUR SEMICONDUCTOR ASSEMBLY AND TESTING REQUIREMENTS. Semiconductor assembly and testing are complex processes which involve significant technological expertise and specialized equipment. Although we are in the process of evaluating additional sources of supply, we currently depend on our affiliate ST Assembly Test Services Ltd, or STATS, for almost all of the assembly and test services we offer our customers. STATS may, from time to time, experience production interruption due to, among other things, technical problems occurring during the assembly and testing processes. Because STATS is our major provider of these services, any prolonged interruption in STATS' operations or the termination of our affiliation with STATS could seriously harm our company. WE ARE SUBJECT TO THE RISK OF LOSS DUE TO FIRE BECAUSE THE MATERIALS WE USE IN OUR MANUFACTURING PROCESSES ARE HIGHLY FLAMMABLE. We use highly flammable materials such as silane and hydrogen in our manufacturing processes and are therefore subject to the risk of loss arising from fires. Although we have implemented industry acceptable risk management controls at our manufacturing locations, the risk of fire associated with these materials cannot be completely eliminated and, in the past, we have had minor interruptions in production as a result of fire. We maintain insurance policies to guard against losses caused by fire. While we believe our insurance coverage for damage to our property and disruption of our business due to fire is adequate, we cannot assure you that it would be sufficient to cover all of our potential losses. If any of our fabs were to be damaged or cease operations as a result of a fire, it would temporarily reduce manufacturing capacity and seriously harm our company. OUR FAILURE TO COMPLY WITH CERTAIN ENVIRONMENTAL REGULATIONS COULD SERIOUSLY HARM OUR COMPANY. We are subject to a variety of laws and governmental regulations in Singapore relating to the use, discharge and disposal of toxic or otherwise hazardous materials used in our production process. While we believe that we are currently in compliance in all material respects with such laws and regulations, if we fail to use, discharge or dispose of hazardous materials appropriately, our company could be subject to substantial liability or could be required to suspend or adversely modify our manufacturing operations. In addition, we could be required to pay for the cleanup of our properties if they are found to be contaminated even if we are not responsible for the contamination. We maintain insurance policies to guard against losses resulting from environmental harm caused by our company. While we believe our insurance coverage is adequate, we cannot assure you that it would be sufficient to cover all our potential losses. RISKS RELATING TO OUR INFRASTRUCTURE WE ARE IN THE PROCESS OF CONSTRUCTING A NEW FABRICATION PLANT. Fab 7 is in its design and initial construction phase. While we have taken the project management and planning steps we believe are necessary to complete Fab 7 on schedule and within budget, there are certain uncontrollable events that could delay the project or increase the cost of Fab 7. Such potential events include: - a major design and/or construction change caused by changes to the initial building space utilization plan or equipment layout; - shortages and late delivery of building materials and facility equipment; - a long and intensive wet season that limits construction; - a shortage of foreign construction workers or a change in immigration laws preventing such workers from entering Singapore; - strikes and labor disputes; - on-site construction problems such as industrial accidents, fires and structural collapse; and - delays in securing the necessary governmental approvals and land lease. WE DEPEND ON KEY PERSONNEL AND, DUE TO THE STRONG DEMAND IN SINGAPORE FOR SKILLED LABOR, MAY HAVE DIFFICULTY ATTRACTING SUFFICIENT NUMBERS OF SKILLED EMPLOYEES. Our success depends to a significant extent upon the continued service of our key senior executives and our engineering, marketing, sales, manufacturing, support and other personnel. In addition, in connection with our growth plans, we are likely to need a greater number of experienced engineers and other employees in the future. The competition for skilled employees is intense. Due to the current shortage of experienced personnel in Singapore, we must recruit our personnel internationally. This is more expensive than hiring personnel locally, and therefore increases our operating costs. As of December 31, 1999, a majority of our employees were citizens of countries other than Singapore. We expect demand for personnel in Singapore to increase significantly in the future as new wafer fabrication facilities are established in Singapore. If we were to lose the services of any of our existing key personnel without adequate replacements, or were unable to attract and retain new experienced personnel as we grow, it could seriously harm our company. We do not carry "key person" life insurance on any of our personnel. WE MAY NOT BE ABLE TO MANAGE OUR GROWTH, WHICH COULD SERIOUSLY HARM OUR COMPANY. We have experienced and are currently experiencing a period of significant growth. This growth has placed, and the future growth will continue to place, a significant strain on our managerial, technical, financial, production, operational and other resources. In particular, by expanding our manufacturing facilities and equipping new facilities we may create additional capacity at our fabs, which, if not utilized, would reduce our profitability and could seriously harm our company. YEAR 2000 UPDATE. We crossed over from December 31, 1999 into January 1, 2000 without experiencing any Year 2000-related incidents or disruptions that were harmful to our company. RISKS RELATED TO INVESTMENTS IN A CONTROLLED CORPORATION SINGAPORE TECHNOLOGIES WILL CONTINUE TO CONTROL OUR COMPANY FOLLOWING COMPLETION OF THE GLOBAL OFFERING AND ITS INTERESTS MAY CONFLICT WITH THE INTERESTS OF OUR OTHER SHAREHOLDERS. ST and its affiliates will beneficially own approximately 60.3% of our outstanding ordinary shares following completion of the global offering, or 58.7% if the underwriters exercise their overallotment option in full. As a result, ST will be able to exercise control over many matters requiring approval by our shareholders, including the election of directors and approval of significant corporate transactions. ST also provides us with financing, guarantees some of our debt and enters into forward foreign exchange contracts with us relating to some of our equipment purchase commitments with foreign vendors. While we believe that ST will continue to provide us credit and other support, ST has no obligation to do so and the availability and amount of its support will depend on various factors, including our ability to raise funds without such support and the expenses relating to such fundraising. After completion of the global offering, we will continue to have contractual and other business relationships with ST and its affiliates and may engage in transactions from time to time that are material to us. Although the Audit Committee of our Board of Directors will review all material transactions between our company and ST, circumstances may arise in which the interests of ST and its affiliates could conflict with the interests of our other shareholders. Because ST and its affiliates own a significant portion of our ordinary shares, they could delay or prevent a change in control of our company, even if a transaction of that nature would be beneficial to our other shareholders. Our Articles of Association do not contain a provision requiring that ST and its affiliates own at least a majority of our ordinary shares. Please see "Relationship with Singapore Technologies" for additional information regarding our relationship with ST and its affiliates. RISKS RELATED TO INVESTMENT IN A FOREIGN CORPORATION WE OPERATE INTERNATIONALLY AND ARE THEREFORE AFFECTED BY PROBLEMS IN OTHER COUNTRIES. Our principal customers are located in the United States and Taiwan and our principal suppliers are located in the United States, Japan, Korea and Germany. As a result, we are affected by economic and political conditions in those countries, including: - fluctuations in the value of currencies; - changes in labor conditions; - longer payment cycles; - greater difficulty in collecting accounts receivable; - burdens and costs of compliance with a variety of foreign laws; - political and economic instability; - increases in duties and taxation; - imposition of restrictions on currency conversion or the transfer of funds; - limitations on imports or exports; - expropriation of private enterprises; and - reversal of the current policies (including favorable tax and lending policies) encouraging foreign investment or foreign trade by our host countries. The geographical distances between Asia, the Americas and Europe also create a number of logistical and communications challenges. Although we have not experienced any serious harm in connection with our international operations, we cannot assure you that such problems will not arise in the future. EXCHANGE RATE FLUCTUATIONS MAY AFFECT THE VALUE OF OUR ADSS OR ORDINARY SHARES. Our financial statements are prepared in U.S. dollars. Our net revenue is generally denominated in U.S. dollars and our operating expenses are generally incurred in U.S. dollars and Singapore dollars. Our capital expenditures are generally denominated in U.S. dollars, Japanese yen, Singapore dollars and other currencies. Although we hedge a portion of the resulting net foreign exchange position through the use of forward exchange contracts, we are still affected by fluctuations in exchange rates among the U.S. dollar, the Japanese yen, the Singapore dollar and other currencies. We are particularly affected by fluctuations in the exchange rate between the U.S. dollar and the Singapore dollar. For example, in 1999 substantially all of our revenue and approximately 72.5% of our cost of revenue were denominated in U.S. dollars. If the Singapore dollar strengthens against the U.S. dollar by 2.0%, our cost of revenue will increase by 0.6%. Likewise, if the Singapore dollar weakens against the U.S. dollar by 2.0%, our cost of revenue will decrease by 0.6%. Any significant fluctuation in exchange rates may harm our company. In addition, fluctuations in the exchange rate between the U.S. dollar and the Singapore dollar will affect the U.S. dollar value of our ordinary shares and ADSs, and the value of any cash dividends if paid in U.S. or Singapore dollars. ECONOMIC CONDITIONS IN THE ASIA PACIFIC REGION MAY HAVE A NEGATIVE IMPACT ON OUR REVENUE. A significant portion of our revenue is derived from sales to customers whose semiconductors are used in products that are sold in Japan, Taiwan and other countries in East and Southeast Asia. In 1998, many countries in Asia experienced considerable currency volatility and depreciation, high interest rates and declining asset values. As a result, there was a general decline in business and consumer spending and a decrease in economic growth as compared with prior years. Although Singapore was not materially affected by these events, our results of operations in 1998 were affected by overall regional economic conditions because demand for semiconductor products generally rises as the overall level of economic activity increases and falls as activity decreases. Our results of operations in the future could be negatively impacted if the economic environment in these countries deteriorates. OUR PUBLIC SHAREHOLDERS MAY HAVE MORE DIFFICULTY PROTECTING THEIR INTERESTS THAN THEY WOULD AS SHAREHOLDERS OF A U.S. CORPORATION. Our corporate affairs are governed by our Memorandum and Articles of Association and by the laws governing corporations incorporated in Singapore. The rights of our shareholders and the responsibilities of the members of our Board of Directors under Singapore law may be different from those applicable to a corporation incorporated in the United States. Therefore, our public shareholders may have more difficulty in protecting their interests in connection with actions taken by our management, members of our Board of Directors or our controlling shareholders than they would as shareholders of a corporation incorporated in the United States. For example, controlling shareholders in United States corporations are subject to fiduciary duties while controlling shareholders in Singapore corporations are not subject to such duties. Please see "-- Singapore Technologies will continue to control our company following completion of the global offering and its interests may conflict with the interests of our other shareholders" for a discussion relating to our controlling shareholders, ST and its affiliates. IT MAY BE DIFFICULT FOR YOU TO ENFORCE ANY JUDGMENT OBTAINED IN THE UNITED STATES AGAINST US OR OUR AFFILIATES. Our company is incorporated under the laws of the Republic of Singapore. Many of our directors and executive officers, and some of the experts named in this document, reside outside the United States. In addition, virtually all of our assets and the assets of those persons are located outside the United States. As a result, it may be difficult to enforce in or out of the United States any judgment obtained in the United States against us or any of these persons, including judgments based upon the civil liability provisions of the United States securities laws. In addition, in original actions brought in courts in jurisdictions located outside the United States, it may be difficult for investors to enforce liabilities based upon United States securities laws. We have been advised by Allen & Gledhill, our Singapore legal counsel, that judgments of U.S. courts based on the civil liability provisions of the federal securities laws of the United States are not enforceable in Singapore courts. Allen & Gledhill has also advised us that there is doubt as to whether Singapore courts will enter judgments in original actions brought in Singapore courts based solely upon the civil liability provisions of the federal securities laws of the United States. SINGAPORE LAW CONTAINS PROVISIONS THAT COULD DISCOURAGE A TAKEOVER OF OUR COMPANY. The Companies Act (Chapter 50) of Singapore and the Singapore Code on Takeovers and Mergers contain certain provisions that may delay, deter or prevent a future takeover or change in control of our company. Any person acquiring an interest, either on his or her own or together with parties acting in concert with him or her, in 25% or more of our voting shares must extend a takeover offer for the remaining voting shares in accordance with the Singapore Code on Takeovers and Mergers. A takeover offer is also required to be made if a person holding between 25% and 50% (both inclusive) of the voting rights (either on his or her own or together with parties acting in concert with him or her) acquires an additional 3% of our voting shares in any 12-month period. The preceding provisions may discourage or prevent certain types of transactions involving an actual or threatened change of control of our company. This may harm you because a transaction of that kind may allow you to sell your shares at a price above the prevailing market price. RISKS RELATED TO OUR ADSS AND ORDINARY SHARES AND OUR TRADING MARKET THE SINGAPORE SECURITIES MARKET IS RELATIVELY SMALL AND MORE VOLATILE THAN U.S. MARKETS AND MAY CAUSE THE MARKET PRICE OF OUR ADSS AND ORDINARY SHARES TO FLUCTUATE. The Singapore Exchange Securities Trading Limited, or the Singapore Exchange, is relatively small and more volatile than stock exchanges in the United States and certain other European countries. As of December 31, 1999, there were over 370 Singapore companies listed on the Main Board and SESDAQ of the Singapore Exchange and the aggregate market capitalization of listed equity securities of these companies was approximately US$260 billion. For the year ended December 31, 1998, the average daily equity trading value on the Singapore Exchange (including shares traded on the CLOB International trading system) was approximately US$229 million, with an annualized aggregate trading value of approximately US$57 billion. The relatively small market capitalization of, and trading volume on, the Singapore Exchange may cause the market price of securities of Singapore companies, including our ADSs and our ordinary shares, to fluctuate in both the domestic and the international markets. Please see "Annex B -- The Securities Market of Singapore" for additional information regarding the Singapore securities market. NEW INVESTORS IN OUR COMPANY WILL EXPERIENCE IMMEDIATE AND SUBSTANTIAL DILUTION. The purchase price of the ordinary shares and ADSs offered in the global offering is substantially higher than the net tangible book value of our outstanding ordinary shares. Investors who purchase ordinary shares or ADSs in the global offering will therefore experience immediate and significant dilution in the tangible net book value of their investment. Based on the assumed public offering price of our ordinary shares and ADSs, our current shareholders will have an aggregate unrealized gain of approximately $9.7 billion as a result of the global offering. Please see "Dilution" for additional information regarding the dilutive effect of the global offering. AN ACTIVE OR LIQUID MARKET FOR THE ADSS AND ORDINARY SHARES IS NOT ASSURED. We cannot predict the extent to which the global offering will result in the development of an active, liquid public trading market for our ADSs or ordinary shares offered in the global offering or how liquid that market will be. Active, liquid trading markets generally result in lower price volatility and more efficient execution of buy and sell orders for investors. Liquidity of a securities market is often a function of the volume of the underlying shares that are publicly held by unrelated parties. Although ADS holders are entitled to withdraw the ordinary shares underlying the ADSs from the depositary at any time, there is no public market for our ordinary shares in the United States. YOUR VOTING RIGHTS WITH RESPECT TO THE ADSS ARE LIMITED BY THE TERMS OF THE DEPOSIT AGREEMENT FOR THE ADSS. Holders may exercise voting rights with respect to the ordinary shares represented by ADSs only in accordance with the provisions of the deposit agreement relating to the ADSs. There are no provisions under Singapore law or under our Articles of Association that limit ADS holders' ability to exercise their voting rights through the depositary with respect to the underlying ordinary shares. However, there are practical limitations upon the ability of ADS holders to exercise their voting rights due to the additional procedural steps involved in communicating with such holders. For example, our Articles of Association require us to notify our shareholders at least 14 days in advance of any annual general meeting unless a special resolution is to be passed at that meeting, in which case at least 21 days' notice must be given. Our ordinary shareholders will receive notice directly from us and will be able to exercise their voting rights by either attending the meeting in person or voting by proxy. ADS holders, by comparison, will not receive notice directly from us. Rather, in accordance with the deposit agreement, we will provide the notice to the depositary, which will in turn, as soon as practicable thereafter, mail to holders of ADSs: - the notice of such meeting; - voting instruction forms; and - a statement as to the manner in which instructions may be given by holders. To exercise their voting rights, ADS holders must then instruct the depositary how to vote their shares. Because of this extra procedural step involving the depositary, the process for exercising voting rights will take longer for ADS holders than for holders of ordinary shares. ADSs for which the depositary does not receive timely voting instructions will not be voted at any meeting. Except as described in this document, holders will not be able to exercise voting rights attaching to the ADSs. Please see "Description of Ordinary Shares"

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+RISK FACTORS INVESTING IN OUR COMMON SHARES INVOLVES A HIGH DEGREE OF RISK. IF ANY OF THE FOLLOWING RISKS OCCUR, THE MARKET PRICE OF OUR COMMON SHARES COULD DECLINE AND YOU COULD LOSE ALL OR PART OF YOUR INVESTMENT. BECAUSE WE HAVE A LIMITED OPERATING HISTORY, WE CANNOT BE SURE THAT WE CAN SUCCESSFULLY EXECUTE OUR BUSINESS STRATEGY We did not record revenue from our first product sale until May 1997. We have a limited history of generating significant revenues. Many of our products have only recently been introduced and many of our customers are testing our products for incorporation into live networks. Therefore, you have limited historical financial data and operating results with which to evaluate our business and our prospects. You must consider our prospects in light of the early stage of our business in a new and rapidly evolving market. Our limited operating history may make it difficult for you to assess, based on historical information, whether we can successfully execute our business strategy. If we are unable to successfully execute our business strategy, we would likely not achieve anticipated levels of revenue growth. In this event, we would be unable to achieve profitability or build a sustainable business. WE HAVE A HISTORY OF LOSSES, EXPECT FUTURE LOSSES AND MAY NEVER ACHIEVE OR SUSTAIN PROFITABILITY As of September 30, 1999, we had an accumulated deficit of $121.2 million. We incurred net losses of approximately $29.2 million, $30.8 million, $24.5 million and $9.5 million in the fiscal years ended June 30, 1997, 1998 and 1999 and the three months ended September 30, 1999, respectively. We expect to continue to incur net losses and these losses may be substantial. Furthermore, we expect to generate significant negative cash flow in the future. We will need to generate substantially higher revenues to achieve and sustain profitability and positive cash flow. Our ability to generate future revenues and achieve profitability will depend on a number of factors, many of which are beyond our control. These factors include: - the rate of market acceptance of compact mobile wireless systems; - our ability to compete successfully against much larger GSM communications equipment providers; and - our ability to continue to expand our customer base. Due to these factors, as well as other factors described in this risk factors section, we may be unable to achieve or maintain profitability. If we are unable to achieve or maintain profitability, we will be unable to build a sustainable business. In this event, our share price and the value of your investment would likely decline. OUR QUARTERLY OPERATING RESULTS ARE LIKELY TO FLUCTUATE SIGNIFICANTLY AND MAY FAIL TO MEET THE EXPECTATIONS OF SECURITIES ANALYSTS AND INVESTORS, WHICH MAY CAUSE OUR SHARE PRICE TO DECLINE Our quarterly operating results have fluctuated significantly in the past and are likely to do so in the future. If our operating results do not meet the expectations of securities analysts and investors, our share price is likely to decline. The many factors that could cause our quarterly results to fluctuate include: - any delay in our introduction of new products or product enhancements; - the size and timing of customer orders and our product shipments, which have typically consisted of a relatively small number of units of wireless network systems at the end of each quarter; - the mix of products sold because our various products generate different gross margins; - any delay in shipments caused by component shortages or other manufacturing problems, extended product testing or regulatory issues; - the timing of orders from and shipments to major customers, including possible cancellation of orders and failure of major customers to meet applicable minimum purchase commitments; - the loss of a major customer; - reductions in the selling prices of our products; - cost pressures from shortages of skilled technical employees, increased product development and engineering expenditures and other factors; and - customer responses to announcements of new products and product enhancements by competitors and the entry of new competitors into our market. Due to these and other factors, our results of operations could fluctuate substantially in the future, and quarterly comparisons may not be reliable indicators of future performance. In addition, because many of our expenses for personnel, facilities and equipment are relatively fixed in nature, if revenues fail to meet our expectations, we may not be able to reduce expenses correspondingly. As a result, we would experience greater than expected net losses. If we experience greater than expected net losses, our share price and the value of your investment would likely decline. WE RELY ON A SMALL NUMBER OF CUSTOMERS FOR MOST OF OUR REVENUES, AND A DECREASE IN REVENUES FROM THESE CUSTOMERS COULD SERIOUSLY HARM OUR BUSINESS A small number of customers have accounted for a significant portion of our revenues to date. Net revenues from significant customers as a percentage of our total net revenues in the two most recent fiscal years and the three months ended September 30, 1999 were as follows: <TABLE> <CAPTION> FISCAL YEAR THREE MONTHS ENDED ENDED JUNE 30, SEPTEMBER 30, ---------------------- -------------- 1998 1999 1999 -------- -------- -------------- <S> <C> <C> <C> Nortel Networks.................................... 18% 51% 18% ADC Telecommunications/Microcellular Systems, Ltd.............................................. 47 20 21 Hutchison Telecommunications Group................. 21 8 5 HangZhou Topper Electric Corporation............... -- 2 38 </TABLE> Nortel Networks is one of our principal shareholders, and a Nortel Networks employee is a member of our board of directors. ADC Telecommunications and Hutchison Whampoa, the parent of Hutchison Telecommunications Group, through a wholly-owned subsidiary, are shareholders of ours. Microcellular Systems, Ltd. was created by a spin-off from ADC Telecommunications in May 1999. We expect that the majority of our revenues will continue to depend on sales to a small number of customers. If any key customers experience a downturn in their business or shift their purchases to our competitors, our revenues and operating results would decline. We expect that for the foreseeable future a significant portion of our net revenues will be derived from sales to Nortel Networks and Alcatel. If our revenues, including those expected from Nortel Networks and Alcatel under our purchase and distribution agreements, are lower than expected, we may not be able to quickly reduce expenses because many of our expenses are fixed in the near term. WE HAVE MINIMUM PURCHASE COMMITMENTS FROM NORTEL NETWORKS AND ALCATEL, AND IF THEY FAIL TO MEET THESE COMMITMENTS, THIS FAILURE COULD HARM OUR BUSINESS AND OPERATING RESULTS Nortel Networks and Alcatel have minimum purchase commitments under their respective agreements. We rely in part on these commitments in forecasting production quantities each quarter. We have also committed to Nortel Networks and Alcatel that we will maintain quality, delivery, performance and design standards for our systems. As a result, we bear the risk of carrying excess inventory if Nortel Networks and Alcatel fail to meet their commitments or if we fail to meet ours. From time to time, we have failed to deliver certain product features by specific milestone dates and, as a result, we have renegotiated downward minimum quarterly commitments with Nortel Networks. Nortel Networks did not meet the renegotiated commitments for the quarter ended September 30, 1999. We cannot assure you that these minimum commitments will be met or that they will not be renegotiated downward in the future. Failure of Nortel Networks or Alcatel to meet minimum purchase commitments could cause our revenues and operating results to decline. Furthermore, because Nortel Networks' commitments are larger than Alcatel's, Nortel Networks' failure to meet commitments would harm our operating results to a greater extent than Alcatel's failure to do so. Failure of these companies to meet these commitments could also cause our stock price to decline as a result of a revenue shortfall or greater than anticipated operating losses. WE CURRENTLY DEPEND ON TWO CONTRACT MANUFACTURERS FOR MOST OF OUR PRODUCTS AND PLAN TO USE ONLY A SINGLE CONTRACT MANUFACTURER IN THE FUTURE AND THIS TRANSITION COULD CAUSE DISRUPTIONS IN OUR BUSINESS We depend on two contract manufacturers for most of our products. We do not have long-term supply contracts with our contract manufacturers, and they are not obligated to supply us with products for any specific period, in any specific quantity or at any specific price, except as may be provided in a particular purchase order. None of our products are manufactured by more than one supplier, and we do not expect this to change for the foreseeable future. We plan to consolidate the manufacture of our products with one of our existing contract manufacturers, PEMSTAR, Inc., by the middle of calendar year 2000. We may lose revenue and damage our customer relationships if we do not manage this consolidation effectively. There are risks associated with our dependence on contract manufacturers, including the contract manufacturer's control of capacity allocation, labor relations, production quality and other aspects of the manufacturing process. If we are unable to obtain our products from manufacturers on schedule, revenues from the sale of those products may be delayed or lost, and our reputation, relationship with customers and our business could be harmed. In addition, in the event that a contract manufacturer must be replaced, the disruption to our business and the expense associated with obtaining and qualifying a new contract manufacturer could be substantial. If problems with our contract manufacturers cause us to miss customer delivery schedules or result in unforeseen product quality problems, we may lose customers. As a result, our revenues and our future growth prospects would likely decline. BECAUSE SOME OF OUR KEY COMPONENTS COME FROM A SINGLE SOURCE, OR REQUIRE LONG LEAD TIMES, WE COULD EXPERIENCE UNEXPECTED INTERRUPTIONS WHICH COULD CAUSE OUR OPERATING RESULTS TO SUFFER We believe that a number of our suppliers are sole sources for key components. These key components are complex and difficult to manufacture and require long lead times. In the event of a reduction or interruption of supply, or a degradation in quality, as many as six months could be required before we would begin receiving adequate supplies from other suppliers. Supply interruptions could delay product shipments, causing our revenues and operating results to decline. WE DO NOT TYPICALLY HAVE A SALES BACKLOG AND THEREFORE MAY INCUR EXPENSES FOR EXCESS INVENTORY OR BE UNABLE TO MEET CUSTOMER REQUIREMENTS We do not have a significant backlog because our customers typically give us firm purchase orders with short lead times before requested shipment. However, our contract manufacturers require commitments from us so that they can allocate capacity and be assured of having adequate components and supplies from third parties. Failure by us to accurately estimate product demand could cause us to incur expenses related to excess inventory or prohibit us from meeting customer requirements. OUR PRODUCTS ARE COMPLEX AND MAY HAVE ERRORS OR DEFECTS THAT ARE DETECTED ONLY AFTER DEPLOYMENT IN COMPLEX NETWORKS, WHICH MAY HARM OUR BUSINESS Our products are highly complex and are designed to be deployed in complex networks. Although our products are tested during manufacturing and prior to deployment, they can only be fully tested when deployed in networks with high-call volume. Consequently, our customers may discover errors after the products have been fully deployed. If we are unable to fix errors or other problems that may be identified in full deployment, we could experience: - costs associated with the remediation of any problems; - loss of or delay in revenues; - loss of customers; - failure to achieve market acceptance and loss of market share; - diversion of deployment resources; - increased service and warranty costs; - legal actions by our customers; and - increased insurance costs. In addition, our products often are integrated with other network components. There may be incompatibilities between these components and our products that could significantly harm the service provider or its subscribers. Product problems in the field could require us to incur costs to remedy the problems and subject us to liability for damages caused by the problems. These problems could also harm our reputation and competitive position in the industry. WE MAY EXPERIENCE DIFFICULTIES IN THE INTRODUCTION OF NEW OR ENHANCED PRODUCTS THAT COULD RESULT IN SIGNIFICANT, UNEXPECTED EXPENSES OR DELAY THEIR LAUNCH, WHICH WOULD HARM OUR BUSINESS The development of new or enhanced products is a complex and uncertain process. We may experience design, manufacturing, marketing and other difficulties that could delay or prevent our development, introduction or marketing of new products or product enhancements. We must also effectively manage the transition from old products to new or enhanced products. In particular, we are currently developing a system providing voice communication over the Internet for commercial release in fiscal year 2000. We cannot assure you that we will be able to develop, introduce or manage this or any other new products or product enhancements in a timely manner or at all. Failure to develop new products or product enhancements in a timely manner would substantially decrease market acceptance and sales of our products. FAILURE TO COMPLY WITH REGULATIONS AFFECTING THE TELECOMMUNICATIONS INDUSTRY COULD SERIOUSLY HARM OUR BUSINESS AND RESULTS OF OPERATIONS Our failure to comply with government regulations relating to the telecommunications industry in countries where our products are deployed and failure to comply with any changes to those regulations could seriously harm our business and results of operations. We have not completed all activities necessary to comply with existing regulations and requirements in some of the countries in which we intend to sell our products. Compliance with the regulations of numerous countries could be costly and require delays in deployments. OUR FAILURE TO COMPLY WITH EVOLVING INDUSTRY STANDARDS COULD DELAY OUR INTRODUCTION OF NEW PRODUCTS An international consortium of standards bodies is working to establish the specifications of a future wireless standard and its interoperability with existing standards. Any failure of our products to comply could delay their introduction and require costly and time consuming engineering changes. After the future standard is adopted, any delays in our introduction of next generation products could impair our ability to grow revenues in the future. As a result, we may be unable to achieve or sustain profitability. OUR MARKET OPPORTUNITY COULD BE SIGNIFICANTLY DIMINISHED IN THE EVENT THAT GSM OR ANY SUBSEQUENT GSM-BASED STANDARDS DO NOT CONTINUE TO BE OR ARE NOT WIDELY ADOPTED Our products are designed to utilize only GSM, an international standard for voice and data communications. There are other competing standards including code division multiple access, or CDMA, and time division mutiple access, or TDMA. We currently do not have plans to offer products that utilize these standards. In the event that GSM or any GSM-based standards do not continue to be or are not broadly adopted, our market opportunity could be significantly limited, which would seriously harm our business. WE HAVE A LONG SALES CYCLE, WHICH COULD CONTRIBUTE TO FLUCTUATIONS IN OUR RESULTS OF OPERATIONS AND SHARE PRICE Our sales cycle is typically long and unpredictable, making it difficult to plan our business. The long sales cycle also requires us to invest resources in a possible transaction that may not be recovered if we do not successfully conclude the transaction. Factors that affect the length of our sales cycle include: - time required for testing and evaluation of our products before they are deployed in a network; - size of the deployment; - complexity of the customer's network environment; and - the degree of system configuration necessary to deploy our products. In addition, the emerging and evolving nature of the market for the systems we sell may lead prospective customers to postpone their purchasing decisions. General concerns regarding year 2000 compliance may further delay purchase decisions by prospective customers. Our long and unpredictable sales cycle can result in delayed revenues, difficulty in matching revenues with expenses and increased expenditures, which together may contribute to declines in our results of operations and our share price. INTENSE COMPETITION IN THE WIRELESS MARKET COULD PREVENT US FROM INCREASING OR SUSTAINING REVENUES OR ACHIEVING OR SUSTAINING PROFITABILITY The wireless market is rapidly evolving and highly competitive. We cannot assure you that we will have the financial resources, technical expertise or marketing, manufacturing, distribution and support capabilities to compete successfully in the future. We expect that competition in each of our markets will increase in the future. In the wireless office network market, the primary competing standard for our systems is the digital European cordless telephone standard known as DECT. In the community network market, we compete against wireless local loop networks, which are wireless communication systems that connect users to the public telephone network using radio signals as a substitute for traditional telephone connections. We currently compete against communications equipment providers such as Ericsson, Lucent, Motorola, Nokia and Siemens in the GSM, CDMA, TDMA, DECT and wireless local loop markets. We also compete with our customers Alcatel and Nortel Networks. All of the major communications equipment providers have broad product lines that include at least partial solutions that address our target markets. In addition, we are seeking to sell our products in emerging markets, many of which have less reliable traditional telephone infrastructures than developed countries. If these countries improve the reliability and service of their traditional telephone networks, the demand for our products in these markets could be harmed and our future revenue growth could decline. Many of our competitors and potential competitors have substantially greater name recognition and technical, financial and sales and marketing resources than we have. Such competitors may undertake more extensive marketing campaigns, adopt more aggressive pricing policies and devote substantially more resources to developing new products than we can. Trends toward increased consolidation in the telecommunications industry may increase the size and resources of some of our current competitors and could affect some of our current relationships. Increased competition is likely to result in price reductions, shorter product life cycles, reduced gross margins, longer sales cycles and loss of market share, any of which would seriously harm our business. We cannot assure you that we will be able to compete successfully against current or future competitors. Competitive pressures we face may cause our revenues or growth to decline and may therefore seriously harm our business and results of operations. IF WE ARE UNABLE TO MANAGE OUR GLOBAL OPERATIONS EFFECTIVELY, OUR BUSINESS WOULD BE SERIOUSLY HARMED Substantially all of our revenue to date has been derived from systems intended for installation outside of the United States. In addition to the regulatory issues discussed previously, our operations are subject to the following risks and uncertainties: - legal uncertainties regarding liability, tariffs and other trade barriers; - greater difficulty in accounts receivable collection and longer collection periods; - costs of staffing and managing operations in several countries; - difficulties in protecting intellectual property rights; - changes in currency exchange rates which may make our U.S. dollar-denominated products less competitive in global markets; - the impact of recessions in global economies; and - political and economic instability. We expect to establish manufacturing operations in China during calendar year 2000 which may subject us to all of the risks listed above, particularly the difficulty of protecting intellectual property rights. WE HAVE EXPERIENCED AN INCREASE IN SALES TO COMPANIES IN THE PEOPLES REPUBLIC OF CHINA, AND FUTURE SALES IN CHINA WILL BE SUBJECT TO ECONOMIC AND POLITICAL RISKS In the three months ended September 30, 1999, sales to HangZhou Topper Electric, which is located in the Peoples Republic of China, accounted for 38% of our revenues. China may represent a significant future market opportunity for interWAVE due to its economic growth and the relative inadequacy of its traditional telephone network. Sales in China pose significant additional risks, which include: - potential inability to enforce contracts or take other legal action, including actions to protect intellectual property rights; - difficulty in collecting revenues and risks related to fluctuations in currency exchange rates, particularly when sales are denominated in the local currency rather than in U.S. dollars; - changes in U.S. foreign trade policy towards China which may restrict our ability to export products to or make sales in China, and similar changes in China's policy regarding the U.S.; and - changes in government regulation affecting companies doing business in China, either through export sales or local manufacturing operations. In the event our revenue levels from sales to China increase, we will become increasingly subject to these risks. The occurrence of any of these risks would harm our revenues from China and could in turn cause our revenues or growth to decline and harm our business and results of operations. IF WE FAIL TO IMPROVE OUR OPERATIONAL SYSTEMS AND CONTROLS TO MANAGE FUTURE GROWTH, OUR BUSINESS COULD BE SERIOUSLY HARMED We plan to continue to expand our operations significantly to pursue existing and potential market opportunities. This growth places significant demands on our management and our operational resources. In order to manage growth effectively, we must implement and improve our operational systems, procedures and controls on a timely basis. In addition, we expect that we will need to expand our principal U.S. facilities in the next six to 12 months and may be required to move our offices to a different location. A move could be disruptive to our operations and could delay production or development activities. IF WE ARE UNABLE TO HIRE OR RETAIN KEY PERSONNEL, WE MIGHT NOT BE ABLE TO OPERATE OUR BUSINESS SUCCESSFULLY Our business is highly dependent on our ability to attract, retain and motivate qualified technical and management personnel. Competition is intense for qualified personnel in our industry and in Northern California, where most of our engineering personnel are located, and we may not be successful in attracting and retaining these personnel. We do not have non-compete agreements with any of our key employees. We currently do not maintain key person life insurance on any of our key executives. Our success also depends upon the continuing contributions of our key management and our research, product development, sales and marketing and manufacturing personnel. Many of these would be difficult to replace, in particular Dr. Priscilla Lu, our Chief Executive Officer and Chairman of the Board, Ian Sugarbroad, our President and Chief Operating Officer and Thomas Hubbs, our Executive Vice President and Chief Financial Officer. OUR INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS MAY BE INSUFFICIENT TO PROTECT OUR COMPETITIVE POSITION We cannot assure you that the protection offered by our U.S. patents will be sufficient or that any of our pending U.S. or foreign patent applications will result in the issuance of patents. In addition, competitors in the United States and other countries, many of whom have substantially greater resources, may apply for and obtain patents that will prevent or interfere with our ability to make and sell our products in the U.S. and/or abroad. Unauthorized parties may attempt to design around our patents, copy or otherwise obtain and use our products. We cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in countries where the laws may not protect our proprietary rights as fully as in the United States. Failure to protect our proprietary rights could harm our competitive position and therefore cause our revenues and operating results to decline. On June 28, 1999, we filed a complaint against JetCell Corporation in the United States District Court for the Northern District of California alleging misappropriation of trade secrets and patent infringement. JetCell has filed a series of counterclaims against us, which include allegations of unfair trade practices, unfair competition, defamation, patent misuse and patent invalidity. We are unable to predict the outcome of this litigation and do not expect it to be resolved in the near future. The legal proceedings may be distracting to our management and expensive and the outcome could be adverse to us. If the outcome is adverse to us, we could experience more competition or could be required to license our technology, either of which could harm our business and financial results. See "Legal Proceedings." CLAIMS THAT WE INFRINGE THIRD-PARTY INTELLECTUAL PROPERTY RIGHTS COULD RESULT IN SIGNIFICANT EXPENSES AND RESTRICTIONS ON OUR ABILITY TO SELL OUR PRODUCTS IN PARTICULAR MARKETS From time to time, third parties may assert patent, copyright, trademark and other intellectual property rights to technologies that are important to our business. Any claims could result in costly litigation, divert the efforts of our technical and management personnel, cause product shipment delays, require us to enter into royalty or licensing agreements or prevent us from making or selling certain products. Any of these could seriously harm our operating results. Royalty or licensing agreements, if available, may not be available on commercially reasonable terms, if at all. In addition, in some of our sales agreements, we agree to indemnify our customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. Costs associated with these indemnification obligations could be significant and could cause our operating results and stock price to decline. WE MAY NOT BE ABLE TO LICENSE NECESSARY THIRD-PARTY TECHNOLOGY OR IT MAY BE EXPENSIVE TO DO SO From time to time, we may be required to license technology from third parties to develop new products or product enhancements. We have licensed software for use in our products from Lucent Technologies, TCSI Inc., Trillium Digital Systems Inc., and Wind River Associates. We cannot assure you that third-party licenses will be available to us on commercially reasonable terms, if at all. The inability to obtain any third-party license required to develop new products and product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost which could seriously harm our competitive position, revenues and growth prospects. There are a number of general GSM patents held by different companies which may impact our technology. If any of our products infringe on any of these patents and we are unable to negotiate license agreements, then we may be required to redesign a portion of our product line. WE MAY BE UNABLE TO MEET OUR FUTURE CAPITAL REQUIREMENTS WHICH WOULD LIMIT OUR ABILITY TO GROW AND COMPETE EFFECTIVELY, RESULTING IN SUBSTANTIAL HARM TO OUR BUSINESS AND RESULTS OF OPERATIONS We may require additional funding, which may not be available on terms which are favorable to us. Currently, we do not have a credit facility or any lines of credit. If we issue equity securities, existing shareholders may experience dilution or the new equity securities may have rights, preferences and privileges senior to those of existing shareholders. If additional funds are raised through the issuance of debt securities, such securities would have rights, preferences and privileges senior to holders of common shares. If we cannot raise funds on terms favorable to us, we may not be able to develop or enhance our products, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements. See "Use of Proceeds," "Dilution" and "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources" for more information on our capital requirements. IF WE, OUR SUPPLIERS OR OUR CUSTOMERS FAIL TO BE YEAR 2000 COMPLIANT, OUR BUSINESS COULD BE SEVERELY DISRUPTED The risk that software or hardware may inaccurately process dates beginning in the year 2000 and beyond presents several potential problems for our business. In particular, we are subject to the following: - costs associated with the failure of our products to be year 2000 compliant, including potential warranty or other claims from our customers, which may result in significant expenses to us; - shutdowns or slowdowns of our business as a result of a failure of our internal management systems, which could disrupt our business operations; - interruption of product or component supplies or a reduction in product quality as a result of the failure of systems used by our contract manufacturers or suppliers; and - reductions or deferrals in sales activities as a result of year 2000 compliance problems of our customers. Our products may contain undetected errors or defects associated with year 2000 date functions. Known or unknown errors or defects in our products could result in delay or loss of revenue, diversion of development resources, damage to our reputation, product liability claims or increased service and warranty costs, any of which could significantly harm our business and operating results. Some industry analysts have predicted significant litigation regarding year 2000 compliance issues. It is uncertain whether or to what extent we may be affected by any litigation. If we, our contract manufacturers, suppliers or customers fail to identify and correct any year 2000 problems or unanticipated or unremedied year 2000 problems arise, these failures or problems could result in an interruption in or a failure of our normal business activities and operations. If a year 2000 problem related to a contract manufacturer or supplier occurs, it may be difficult to determine which suppliers' products have caused the problem. These failures could interrupt our operations and damage our relationships with our customers. Due to the general uncertainty inherent in the year 2000 problem, we are unable to determine at this time whether any external year 2000 failures will harm us. Any failure by us, our contract manufacturers or any of our suppliers to be year 2000 compliant could seriously interrupt our manufacturing process, thereby substantially reducing our revenues. We believe our year 2000 worst case scenario would be the failure of a sole or limited source supplier to be year 2000 compliant. Our failure or the failure of one of these suppliers to be year 2000 compliant could seriously interrupt our manufacturing process, thereby substantially reducing our revenues. To date, we have not experienced any material disruption in our operations as a result of year 2000 problems, nor have we incurred any unplanned expenses to address year 2000 concerns. CONTROL BY OUR EXISTING SHAREHOLDERS COULD DISCOURAGE THE POTENTIAL ACQUISITION OF OUR BUSINESS Upon completion of this offering, our executive officers, directors and 5% or greater shareholders and their affiliates will own 30,995,541 shares or approximately 69.9% of our outstanding common shares assuming the exercise of all warrants and options held by them. Acting together, these shareholders would be able to control all matters requiring approval by shareholders, including the election of directors. This concentration of ownership could have the effect of delaying or preventing a change in control of our business or otherwise discouraging a potential acquirer from attempting to obtain control of us, which could prevent our shareholders from realizing a premium over the market price for their common shares. OUR BYE-LAWS MAY DISCOURAGE POTENTIAL ACQUISITIONS OF OUR BUSINESS Some of our bye-laws and Bermuda law may discourage, delay or prevent a merger or acquisition that shareholders may consider favorable. This may reduce the market price of our common shares. A summary of these provisions is included in "Description of Share Capital--Antitakeover Effects of Some Provisions of Memorandum of Association and Bye-laws." OUR BYE-LAWS PROVIDE FOR WAIVER OF CLAIMS BY SHAREHOLDERS AND INDEMNIFY DIRECTORS AND OFFICERS Our bye-laws provide for a broad indemnification of actions of directors and officers. Under the bye-laws, the shareholders agree to waive claims against directors and officers for their actions in the performance of their duties, except for acts of fraud or dishonesty. These waivers will not apply to claims arising under the United States federal securities laws and will not apply to the extent that they conflict with provisions of the laws of Bermuda or with the fiduciary duties of our directors and officers. OUR OPERATIONS BASED IN BERMUDA MAY BE SUBJECT TO UNITED STATES TAXATION, WHICH COULD SIGNIFICANTLY HARM OUR BUSINESS AND OPERATING RESULTS Except for our United States subsidiary, we do not consider ourselves to be engaged in a trade or business in the United States. Our United States subsidiary is subject to United States taxation on its worldwide income, and dividends from our United States subsidiary are subject to United States witholding tax. We and our non-U.S. subsidiaries would, however, be subject to United States federal income tax on income related to the conduct of a trade or business in the U.S. If we were determined to be subject to United States taxation, our financial results would be significantly harmed. We cannot assure you that the Internal Revenue Service will not contend that our Bermuda-based operations are engaged in a United States trade or business and, therefore, are subject to United States income taxation. See "Taxation" for more information on the tax consequences of operating outside the United States. A SUBSTANTIAL NUMBER OF OUR COMMON SHARES WILL BECOME AVAILABLE FOR SALE IN THE PUBLIC MARKET SIMULTANEOUSLY, WHICH COULD CAUSE THE MARKET PRICE OF OUR SHARES TO DECLINE Sales of substantial amounts of our common shares in the public market following this offering or the awareness that a large number of shares is available for sale could cause the market price of our common shares to decline. Upon the expiration of lock-up agreements restricting the sale of shares by our current shareholders, 28,725,805 of our common shares will become eligible for immediate sale. Prior to such expiration date, Salomon Smith Barney may, in its sole discretion and at any time, release all or any portion of the securities subject to lock-up agreements. Sales of our common shares held by existing shareholders could cause the market price of our stock to decline. WE MAY APPLY THE PROCEEDS OF THIS OFFERING TO USES THAT DO NOT IMPROVE OUR OPERATING RESULTS OR MARKET VALUE We will have considerable discretion to use the net proceeds of this offering for our business, and you will not have the opportunity as part of your investment decision to assess whether the proceeds are being used appropriately. The net proceeds may be used for corporate purposes that do not improve our operating results or our market value. Pending application of the net proceeds, they may be placed in investments that do not produce income or that lose value. See "Use of Proceeds" for more information on our application of the net proceeds. INVESTORS IN THIS OFFERING WILL EXPERIENCE AN IMMEDIATE AND SUBSTANTIAL DILUTION IN THE BOOK VALUE OF THEIR INVESTMENT The per share book value of the common shares, adjusted to reflect the net proceeds we receive from this offering, will be substantially below the price paid by new investors in this offering. Investors in this offering will therefore incur immediate and substantial dilution of $7.58 per share (at an assumed initial public offering price of $11.00). See "Dilution."

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+RISK FACTORS You should carefully consider the risks described below before making a decision to invest in our common stock. RISKS RELATED TO OUR BUSINESS AND FINANCIAL PERFORMANCE OUR LIMITED OPERATING HISTORY MAY MAKE IT DIFFICULT TO VALUE AND EVALUATE OUR BUSINESS AND OUR FUTURE PROSPECTS We commenced operations in September 1997 and commercially released our first product in the first quarter of 1999. Your evaluation of the risks and uncertainties of our business will be difficult because of our limited operating history. In addition, our limited operating history means that we have less insight into how technological and market trends may affect our business. The revenue and income potential of our business and market are unproven. You must consider our business and prospects in light of the risks and difficulties typically encountered by companies in their early stages of development, particularly those in new, rapidly evolving and highly competitive markets such as the market for broadband access solutions. WE HAVE INCURRED SUBSTANTIAL LOSSES TO DATE AND MAY NOT BE ABLE TO ACHIEVE OR MAINTAIN PROFITABILITY, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE Since we began operations, we have incurred net losses in every fiscal period. We incurred a net loss of $9.1 million in the first six months of 2000 and our accumulated deficit through June 30, 2000 was $25.6 million. We expect to incur net losses in the future. Our operating losses have been due in part to the commitment of significant resources to our research and development and sales and marketing organizations. We expect our expenses to continue to increase in an effort to develop our business and, as a result, we will need to generate significant revenue to achieve profitability. We cannot be certain if or when we will become profitable. Our failure to become profitable within the timeframe expected by investors may adversely affect the market price of our common stock. UNEXPECTED FLUCTUATIONS IN OUR OPERATING RESULTS MAY CAUSE OUR STOCK PRICE TO DECLINE Our operating results are difficult to forecast and may fluctuate significantly from quarter to quarter. As a result of our limited operating history, we do not have historical financial data for a significant number of periods upon which to forecast quarterly financial performance. It is likely that in some future quarters, our operating results may fall below the expectations of investors or securities analysts, which could cause the price of our common stock to fall substantially. IF WE FAIL TO INCREASE OUR REVENUE, OR IF WE EXPERIENCE DELAYS IN GENERATING REVENUE, WE WILL CONTINUE TO INCUR SUBSTANTIAL OPERATING LOSSES. We plan to significantly increase our operating expense to fund greater levels of research and development, expand our sales and marketing operations, broaden our customer support capabilities and develop new distribution channels. We also plan to expand our general and administrative capabilities to address the demands resulting from this offering and the continued growth of our business. Our operating expenses are largely based on anticipated personnel requirements and revenue trends, and a high percentage of our expenses are, and will continue to be, fixed. In addition, we may be required to spend more in research and development than originally budgeted in order to respond to industry trends. As a result, if we fail to increase our revenue, or if we experience delays in generating revenue, we will continue to incur substantial operating losses. THERE IS INTENSE COMPETITION IN THE MARKET FOR BROADBAND ACCESS SOLUTIONS AND IF WE FAIL TO COMPETE SUCCESSFULLY, OUR REVENUE COULD DECLINE AND WE COULD EXPERIENCE ADDITIONAL LOSSES The market for broadband access solutions is new, rapidly evolving and very competitive. We expect competition in this market to increase as a result of a number of factors, including the entrance of new or larger competitors and the introduction of new products or technologies. This competition could, among other things: - divert sales from us; - force us to charge lower prices; and - adversely affect our strategic relationships with manufacturers, resellers and others. If any of these risks occurred, our revenues could decline, our gross margins could decrease, our expenses could increase and we could experience additional losses. Our principal competitors may be different depending on the market we target, and include large networking equipment companies such as Alcatel, Cisco Systems, Lucent Technologies, Marconi(Fore) and Nortel Networks, as well as companies such as Accelerated Networks, ADC Kentrox, and Tiara Networks. Many of our current and potential competitors are large public companies that have longer operating histories and significantly greater financial, technical, marketing and other resources than we do. As a result, these competitors are able to devote greater resources to the development, promotion, sale and support of their products. In addition, competitors with large market capitalization or cash reserves are much better positioned than we are to acquire other companies, including our competitors, and thereby acquire new technologies or products that may displace our product lines. WE PURCHASE SEVERAL OF OUR KEY COMPONENTS FROM SINGLE SOURCES, AND WE COULD LOSE REVENUE AND MARKET SHARE IF WE ARE UNABLE TO OBTAIN A SUFFICIENT SUPPLY OF THOSE COMPONENTS Several key components of our products are currently available from single or limited sources with whom we have no guaranteed supply agreements, including: - programmable chips supplied by Lucent Technologies; - asynchronous transfer mode, or ATM, chips supplied by Conexant Systems Inc.; and - circuit emulation chips supplied by PMC-Sierra, Inc. If we are unable to obtain a sufficient supply of these or other critical components from our current vendors: - we may be unable to manufacture and ship our products on a timely basis, which could result in lost or delayed revenue, harm to our reputation, increased manufacturing costs and exposure to claims by our customers; and - we may be forced either to develop alternative sources of supply or to modify the design of our products to use more readily available components, which may take a long time and may involve significant additional expense. For example, during the first quarter of 2000, we encountered delays in receiving programmable chips used in our A-1240 product, which resulted in production delays. In addition, our vendors may increase their prices for these components. Accordingly, the lack of alternative sources for these components may also force us to pay higher prices for these components, which would cause our gross margins to decrease. WE ARE ENTIRELY DEPENDENT ON OUR LINE OF BROADBAND ACCESS PLATFORM PRODUCTS AND OUR PRODUCTS MAY NOT BE READILY ACCEPTED Widespread commercial acceptance of our products is critical to our future success. To date, our A-1000, A-2000, A-1240, A-3010 and A-4000 products are the only products that we have sold and we expect that revenue from these products will account for a substantial portion of our revenue for the foreseeable future. We intend to develop and introduce new products and enhancements to existing products in the future. If our target customers do not adopt, purchase and successfully deploy our current and planned products, our revenue will not grow significantly. The acceptance of our products may be hindered by: - the failure of prospective customers to recognize the value of broadband access platform products; - the reluctance of our prospective customers to replace or expand their current access equipment, which may be supplied by more established vendors, with our products; and - the emergence of new technologies or industry standards that could cause our products to be less competitive or become obsolete. BECAUSE MOST OF OUR SALES ARE MADE UNDER SHORT-TERM PURCHASE ORDERS, WE MAY EXPEND SIGNIFICANT RESOURCES AND BE UNABLE TO RECOVER THE COSTS IF OUR CUSTOMERS FAIL TO PURCHASE ADDITIONAL PRODUCTS Our contracts and purchase orders are separately negotiated with each of our customers and the terms may vary widely. A majority of our sales are made under short-term purchase orders for one or a few of our products at one time instead of long-term contracts for large scale deployment of our products. These purchase orders do not ensure that they will purchase any additional products other than those specifically listed in the order. Moreover, since we believe that these purchase orders represent the early portion of longer term customer programs, we expend significant financial and personnel resources and expand our operations to be able to fulfill these programs. If our customers fail to purchase additional products to expand their programs as we expect, we may be unable to recover the costs we incurred. OUR CUSTOMER CONTRACTS ALLOW OUR CUSTOMERS TO TERMINATE WITHOUT SIGNIFICANT PENALTIES Our contracts are generally non-exclusive and contain provisions allowing our customers to terminate them without significant penalties. Our contracts also may specify the achievement of shipment, delivery and installation commitments. We are generally able to meet these commitments or negotiate extensions with our customers. However, if we fail to meet these commitments in a timely manner, our customers may choose to terminate their contracts with us or impose monetary penalties. If our customers elect to terminate their contracts with us, our future revenues would be reduced. WE DEPEND UPON A SINGLE CONTRACT MANUFACTURER TO MANUFACTURE SUBSTANTIALLY ALL OF OUR PRODUCTS. IF THAT MANUFACTURER IS UNABLE OR UNWILLING TO MANUFACTURE A SUFFICIENT QUANTITY OF OUR PRODUCTS, OUR REVENUE MAY DECLINE AND OUR CUSTOMER RELATIONSHIPS MAY BE DAMAGED We currently subcontract the manufacturing and testing of substantially all of our products to Benchmark Electronics, an independent manufacturer with whom we have no long-term agreement. Our reliance on a single manufacturer exposes us to a number of risks, including reduced control over manufacturing capacity, product completion and delivery times, product quality and manufacturing costs. If, as we anticipate, we experience increased demand for our products and introduce new products and product enhancements, the challenges we face in managing our relationship with Benchmark will be increased. If Benchmark is unable or unwilling to manufacture a sufficient quantity of products for us, on the time schedules and with the quality that we demand: - we may not be able to fulfill customer orders on a timely basis; and - we may be forced to engage additional or replacement manufacturers, which is expensive and time consuming. If that occurs, our revenue may decline and our customer relationships may be damaged. IF WE FAIL TO PREDICT OUR MANUFACTURING AND COMPONENT REQUIREMENTS ACCURATELY, WE COULD INCUR ADDITIONAL COSTS OR EXPERIENCE MANUFACTURING DELAYS We provide forecasts of our demand to our contract manufacturer and component vendors up to six months prior to scheduled delivery of products to our customers. If we overestimate our requirements, we may have excess inventory, which could increase our costs and harm our relationships with our contract manufacturer and component vendors by reducing our future orders. If we underestimate our requirements, we may have an inadequate inventory of components. Inadequate inventory could interrupt manufacturing of our products and result in delays in shipments. In addition, lead times for materials and components that we order are long and depend on factors such as the procedures of, or contract terms with, a specific supplier and demand for each component at a given time. In the case of some components in short supply, component vendors have imposed strict allocations that limit the number of these components they will supply to a given customer in a specified time period. These vendors may choose to increase allocations to larger, more established companies, which could reduce our allocations and harm our ability to manufacture our products. DUE TO THE LONG AND UNPREDICTABLE SALES CYCLE FOR OUR PRODUCTS, THE TIMING OF REVENUE IS DIFFICULT TO PREDICT AND MAY CAUSE OUR OPERATING RESULTS TO FLUCTUATE UNEXPECTEDLY The sales and deployment cycle for our products is lengthy and varies substantially from customer to customer; it may extend for six months or more. The length of our sales cycle may cause our revenue and operating results to vary unexpectedly from quarter to quarter. A customer's decision to purchase our products involves a significant commitment of its resources and a lengthy evaluation and product qualification process. Consequently, we may incur substantial expenses and devote senior management attention to potential relationships that never materialize, in which event our investments will largely be lost and we may miss other opportunities. BECAUSE WE DERIVE A SUBSTANTIAL PORTION OF OUR REVENUE FROM A LIMITED NUMBER OF CUSTOMERS, ANY LOSS OF OR DELAY IN RECEIVING REVENUE FROM THOSE CUSTOMERS COULD SIGNIFICANTLY DAMAGE OUR FINANCIAL PERFORMANCE We have historically derived a significant portion of our revenue from a relatively small number of customers. If any of these customers stop or delay purchasing products or services from us, our financial performance would be negatively impacted. For the year ended December 31, 1999, 2nd Century Communications and AccessLan accounted for 22% and 53% of our revenue. These same customers accounted for 11% and 10% of our revenue for the six months ended June 30, 2000. One additional customer, Broadband Office, accounted for 53% of our revenue for the six months ended June 30, 2000. Most of our customers are not contractually obligated to purchase future products or services from us, and they may discontinue doing so at any time. In addition, although our largest customers will probably vary from period to period, we anticipate that a small number of customers will continue to represent a large percentage of our revenue in any given fiscal period. Accordingly, the failure to obtain a significant order from a customer within the fiscal period expected by us could have a significant adverse effect on our financial performance for that fiscal period. WE ANTICIPATE THAT THE AVERAGE SELLING PRICES OF OUR PRODUCTS WILL DECLINE, WHICH COULD REDUCE OUR GROSS MARGINS AND REVENUE Our industry has experienced rapid erosion of average product selling prices. We anticipate that the average selling prices of our products will decline in response to competitive pressures, increased sales discounts, new product introductions by our competitors or other factors. We are seeking to improve our product design to reduce our costs and increase our sales. If we are unable to do so, declines in average selling prices will reduce our gross margins and revenue. IF NETWORK SERVICE PROVIDERS CHOOSE A PROTOCOL OTHER THAN ATM FOR THEIR CORE NETWORKS AND WE ARE NOT ABLE TO ADAPT TO THE CHANGE, OUR TARGET MARKET COULD BE REDUCED While we have designed a product that is adaptable to many communications protocols, our initial architecture is based on an ATM infrastructure. In the service providers' networks ATM competes with other protocols such as time division multiplexing (TDM) and Internet protocol (IP). We believe that an eventual migration to an IP-based protocol is possible. To the extent that network service providers choose a protocol other than ATM for their core networks, we may not be able to react in time or adapt to the change and our target market could be substantially reduced. IF WE ARE NOT SUCCESSFUL IN DEVELOPING AND MARKETING, OR IF WE ARE DELAYED IN INTRODUCING, NEW AND ENHANCED PRODUCTS AND FEATURES THAT KEEP PACE WITH TECHNOLOGY AND OUR CUSTOMERS' NEEDS AND EXPECTATIONS, OUR SALES AND COMPETITIVE POSITION WILL SUFFER The market for broadband access solutions is characterized by rapidly changing technologies, frequent new product introductions and evolving customer requirements and industry standards. In order to remain competitive, we will need to introduce on a timely basis new products or product enhancements that offer significantly improved performance and features, at lower prices, and we may not be successful in doing so. Some prior versions of our products were released behind schedule, and this may happen again in the future. Delays in introducing new products and features, or the introduction of new products which do not meet the evolving demands of our customers, could damage our reputation and cause a loss of or delay in revenue. IF WE DO NOT EXPAND OUR DIRECT AND INDIRECT SALES CHANNELS, WE MAY BE UNABLE TO INCREASE MARKET AWARENESS AND SALES OF OUR PRODUCTS, WHICH MAY PREVENT US FROM ACHIEVING AND MAINTAINING PROFITABILITY Our products and services require a technical sales effort targeted at several key people within each of our prospective customers' organizations. Our sales efforts require the attention of sales personnel and specialized system engineers with extensive experience in networking technologies. Competition for these individuals is intense, and we may not be able to hire sufficient numbers of qualified sales personnel and specialized system engineers. We also plan to expand our relationships with resellers and original equipment manufacturers. If we fail to develop or cultivate relationships with significant resellers or original equipment manufacturers, or if these resellers and original equipment manufacturers are not successful in their sales efforts, our business may be harmed. Many of our resellers also sell our competitors' products. Failure to expand these channels could adversely affect our revenues and operating results. IF WE DO NOT EXPAND OUR CUSTOMER SERVICE AND SUPPORT ORGANIZATION, WE MAY BE UNABLE TO INCREASE OUR SALES In response to our growing base of product installations, we will need to increase our customer service and support organization to support new and existing customers. We generally do not enter into service contracts as part of our sales process, and our products have not required extensive servicing to date. However, as our product base continues to expand, we intend to offer an enhanced level of customer support on a post-product sale basis both to generate additional revenue opportunities and to distinguish us from our competitors. Our products are complex and require highly-trained customer service and support personnel. Hiring customer service and support personnel is difficult in our industry due to the limited number of people available with the necessary technical skills. If we are unable to expand our customer service and support organization and train our personnel rapidly, we may not be able to increase sales. IF WE ARE NOT ABLE TO HIRE AND RETAIN QUALIFIED PERSONNEL, OR IF WE LOSE KEY PERSONNEL, WE MAY BE UNABLE TO MANAGE OR GROW OUR BUSINESS The growth of our business and revenue depends in large part upon our ability to attract and retain sufficient numbers of highly skilled employees, particularly qualified sales and engineering personnel. Qualified personnel are in great demand throughout our industry, particularly in the Washington, D.C. metropolitan area. We may not be successful in hiring and retaining the skilled personnel that we need. Our future success also depends to a significant degree on the skills and efforts of Asghar Mostafa, our co-founder, Chairman of the Board and Chief Executive Officer, and on the ability of our other executive officers and members of senior management to work effectively as a team. The loss of the services of Mr. Mostafa or one or more of our other executive officers or senior management members could have a material adverse effect on our financial performance and ability to compete. OUR COMPANY IS GROWING RAPIDLY AND WE MAY BE UNABLE TO MANAGE OUR GROWTH EFFECTIVELY, WHICH COULD RESULT IN LOST SALES OR DISRUPTIONS TO OUR BUSINESS Our failure to effectively manage our recent and anticipated growth could have a material adverse effect on the quality of our products, our ability to retain key personnel and our financial performance. From June 30, 1999 to June 30, 2000, the number of our employees increased from 50 to 122. In addition, the proceeds of this offering will be used in part to further expand our operations and increase the number of our employees. This growth has strained, and may further strain, our management, operational systems and other resources. To manage our growth effectively, we must be able to enhance our financial and accounting systems and controls, integrate new personnel and manage expanded operations. We may not be able to do so. WE ARE BEGINNING TO EXPAND OUR INTERNATIONAL BUSINESS, WHICH EXPOSES US TO ADDITIONAL RISKS THAT WE DO NOT FACE IN OUR U.S. BUSINESS In 1999, we derived approximately 10% of our revenue from sales outside the United States, and we expect that percentage to increase as our business grows. An expanded international business exposes us to a number of risks that we do not have to address in our U.S. operations. These risks include: - longer sales cycles; - challenges and costs inherent in managing geographically dispersed operations; - protectionist laws and business practices that favor local competitors; - difficulties in finding and managing local resellers; - diverse and changing governmental laws and regulations, including greater regulation of the telecommunications industry; and - foreign currency exchange rate fluctuations. If we are unsuccessful in addressing these risks, our international business will not achieve the revenue or profits we expect. IF OUR PRODUCTS DO NOT COMPLY WITH EVOLVING INDUSTRY STANDARDS, WE MAY LOSE SALES AND INCUR ADDITIONAL EXPENSES Our success depends in part on both the adoption of industry standards for technologies in the broadband access solutions market and our products' compliance with those industry standards as different standards emerge, evolve and achieve acceptance. The absence of industry standards for a particular technology may prevent widespread adoption of products based on that technology. In addition, because many technological developments occur prior to the adoption of related industry standards, we may develop products that do not comply with the industry standards that are eventually adopted, which would hinder our ability to sell those products. Moreover, if a competitor obtains a leadership position in selling broadband access products, that competitor may have the ability to establish de facto standards within the industry. IF OUR PRODUCTS CONTAIN DEFECTS OR FAIL TO PERFORM PROPERLY OR WORK EFFECTIVELY WITH OUR CUSTOMERS' NETWORKS, WE COULD LOSE REVENUE AND INCUR DAMAGE TO OUR REPUTATION AND LIABILITY TO OUR CUSTOMERS Our products must work effectively with our customers' existing networks, which typically include products from a variety of different vendors and utilize multiple protocol standards. The complexity of these networks makes it difficult for us to ensure that our products will function properly within these networks and also makes it difficult for us to identify the source of any problems which occur in the operation of our products. Despite testing by us and our customers, our products may contain undetected software or hardware errors which result in product failures or poor product performance. We have experienced such errors in the past in connection with new products and product upgrades. We expect that such errors will be found from time to time in new or enhanced products after we have already shipped the products. If our products contain defects or fail to work properly, we may: - suffer a loss of or delay in revenue; - incur additional expenses in our efforts to identify and remedy the problems; - suffer damage to our reputation; and - be exposed to damage claims by our customers. CLAIMS BY NORTEL NETWORKS OR OTHER COMPANIES THAT WE ARE INFRINGING THEIR PROPRIETARY RIGHTS COULD HINDER OR BLOCK OUR ABILITY TO SELL OUR PRODUCTS, SUBJECT US TO SIGNIFICANT MONETARY LIABILITY AND DIVERT THE TIME AND ATTENTION OF OUR MANAGEMENT The broadband access equipment industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights. In particular, leading companies in the data communications and networking markets have extensive patent portfolios with respect to networking technology. We recently received a letter from Nortel Networks Corporation alleging that a specific feature of our products infringes one of Nortel's patents relating to inverse multiplexing over ATM. We believe that our products do not infringe the relevant Nortel patent and we intend to contest this claim vigorously. However, we cannot assure you that we will prevail in our objection to this claim or any other claim Nortel may make with respect to other patents it owns, nor can we assure you that this dispute will not result in litigation or that an adverse result or judgment will not adversely affect our financial condition. The Nortel claim could be time-consuming, result in costly litigation and diversion of technical and management personnel, or require us to develop non-infringing technology. If Nortel succeeds in its claim, we would need to enter into royalty or license agreements. These royalty or license agreements, if required, may not be available on acceptable terms, if at all. We expect that we may increasingly be subject to infringement claims as the numbers of products and competitors in the market for broadband access equipment grows and the functionality of products overlaps. If there is a successful claim of infringement or if we fail to develop non-infringing technology or license proprietary rights on a timely basis that may become necessary, our ability to use technologies, products, and brand names may be limited and our business may be harmed. OUR COMPETITIVE POSITION WOULD BE ADVERSELY AFFECTED IF WE WERE UNABLE TO PROTECT OUR PROPRIETARY RIGHTS Our success and competitiveness are dependent to a significant degree on the protection of our proprietary rights. We rely primarily on a combination of copyrights, trademarks, trade secret laws and contractual restrictions and, to a lesser extent, on patents to protect our proprietary rights. We have one U.S. patent, and we have filed a corresponding application under the Patent Cooperation Treaty relating to the management of tunneling protocols. There can be no assurance that these patent applications will be approved, that any issued patents will protect our intellectual property or that third parties will not challenge them. We enter into confidentiality or license agreements with our employees, consultants and corporate partners, and control access to and distribution of our software, documentation and other proprietary information. Despite these precautions, we cannot guarantee that the steps we have taken to protect our proprietary rights will be adequate to deter misappropriation of our intellectual property. Others may be able to copy or reverse engineer aspects of our products, to obtain and use information that we regard as proprietary or to independently develop similar technology. If we are unable to protect our trademarks and other proprietary rights against unauthorized use by others, our reputation and brand name may be damaged and our competitive position may be significantly harmed. IF WE MAKE ACQUISITIONS OR STRATEGIC INVESTMENTS, OUR STOCKHOLDERS COULD BE DILUTED, WE COULD INCUR ADDITIONAL DEBT, AND WE COULD ASSUME ADDITIONAL CONTINGENT LIABILITIES We intend to consider investments in complementary companies, products or technologies. While we have no current agreements to do so, we may buy businesses, products or technologies in the future. If we make an acquisition or investment, we may: - issue stock that would dilute your stock ownership; - incur debt which would restrict our cash flow; - assume liabilities which may result in additional costs; - incur amortization expenses related to goodwill and other intangible assets; or - incur large and immediate write-offs. WE MAY NOT BE ABLE TO SUCCESSFULLY INTEGRATE OR MANAGE THE ACQUISITIONS OR INVESTMENTS WE MAKE We have not completed any acquisitions or investments to date, so, as a company, we have no experience in this area. Therefore, acquisitions or investments made by us could involve numerous risks, including: - problems combining the purchased operations, technologies or products; - unanticipated costs; - diversion of management's attention from our core business; - adverse effects on existing business relationships with suppliers and customers; - risks associated with entering markets in which we have no or limited prior experience; and - potential loss of key employees, particularly those of the purchased organizations. We may not be able to successfully integrate businesses, products, technologies or personnel that we might acquire in the future. Any failure to do so could disrupt our business and seriously harm our financial condition. WE MAY NEED ADDITIONAL CAPITAL TO FUND OUR OPERATIONS, WHICH MAY NOT BE AVAILABLE At June 30, 2000, we had approximately $25.5 million in cash, cash equivalents and marketable securities. We believe that these amounts, combined with proceeds from this offering and cash anticipated to be available from future operations, will enable us to meet our working capital and capital expenditure requirements for at least the next 12 months. However, if cash from available sources is insufficient, or if cash is used to acquire complementary companies, products or technologies, or for other uses not presently planned, we may need additional capital. The development and marketing of new and enhanced products and the expansion of our sales channels and associated support personnel will require a significant commitment of resources. In addition, if the market for broadband access solutions develops at a slower pace than anticipated or if we fail to establish significant market share and achieve a meaningful level of revenue, we may continue to incur significant operating losses and utilize significant amounts of capital. As a result, we could be required to raise substantial additional capital. Additional capital may not be available to us at all, or if available, may be available only on unfavorable terms. Any inability to raise additional capital when we require it would materially adversely affect our business, results of operations and financial condition. RISKS RELATED TO THE SECURITIES MARKETS AND THIS OFFERING STOCK MARKET VOLATILITY HAS INCREASED, MAKING YOUR INVESTMENT MORE RISKY The price at which our common stock will trade following this offering is likely to be highly volatile and may fluctuate substantially. The price of the common stock that will prevail in the market after this offering may be higher or lower than the price you pay, depending on many factors, some of which are beyond our control. In particular, given the limited amount of our product sales and our limited number of customers, the announcement of any significant customer developments, awards or losses or of any significant partnerships or acquisitions by us or our competitors could have a material adverse effect on our stock price. In addition, the stock markets, particularly the Nasdaq National Market, on which we expect our common stock to be listed, have experienced extreme price and volume fluctuations. These fluctuations have particularly affected the market prices of equity securities of technology related companies and have often been unrelated or disproportionate to the operating performance of those companies. THE SIGNIFICANT CONCENTRATION OF OWNERSHIP OF OUR COMMON STOCK WILL LIMIT YOUR ABILITY TO INFLUENCE CORPORATE ACTIONS Immediately following this offering, our executive officers, directors and their affiliates will together own approximately 71% of our outstanding common stock. As a result, those stockholders, if they act together, will be able to determine the outcome of the vote on any matter requiring stockholder approval, including the election of directors and the approval of significant corporate transactions. This concentration of ownership may have the effect of delaying, preventing or deterring a change in control of our company, could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company and might affect the market price of our common stock. SOME PROVISIONS OF OUR CHARTER AND BY-LAWS MAY DELAY OR PREVENT TRANSACTIONS THAT MANY STOCKHOLDERS MAY FAVOR Some provisions of our certificate of incorporation and by-laws may have the effect of delaying, discouraging, or preventing a merger or acquisition that our stockholders may consider favorable, including transactions in which stockholders might receive a premium for their shares. These provisions include: - authorization of the issuance of "blank check" preferred stock without the need for action by stockholders; - a classified board of directors with staggered three-year terms; - inability of stockholders to call special meetings of stockholders or act by written consent; and - advance notice requirements for proposing matters that can be acted on by stockholders at stockholder meetings. Some provisions of Delaware law may also discourage, delay or prevent someone from acquiring us or merging with us. See "Description of Securities -- Delaware Law and Certain Charter and By-Law Provisions; Anti-Takeover Effects" on page 56 for more detailed information on these provisions. SUBSTANTIAL FUTURE SALES OF OUR COMMON STOCK IN THE PUBLIC MARKET COULD CAUSE THE MARKET PRICE OF OUR COMMON STOCK TO FALL Additional sales of our common stock in the public market after this offering, or the perception that such sales could occur, could cause the market price of our common stock to decline. Upon completion of this offering, we will have 41,115,883 shares of common stock outstanding. See "Prospectus Summary -- The Offering" on page 3 for a detailed discussion of shares included and excluded from this number. The 6,250,000 shares sold in this offering will be freely transferable without restriction or registration under the Securities Act of 1933. Based on shares outstanding as of August 31, 2000, the remaining shares of common stock outstanding after this offering will be available for sale as follows: <TABLE> <CAPTION> DAYS AFTER DATE OF APPROXIMATE SHARES THIS PROSPECTUS ELIGIBLE FOR FUTURE SALE COMMENT ------------------ ------------------------ ------- <S> <C> <C> 90 days after effectiveness..... 79,500 Eligible for sale under Rule 144 or Rule 701 180 days after effectiveness.... 34,786,383 Eligible for sale upon expiration of lock-up </TABLE> In addition, Morgan Stanley & Co. Incorporated may, in its sole discretion, at any time without notice, release all or any portion of the shares subject to the lock-up agreements, which would result in more shares being available for sale in the public market at an earlier date. Sales of common stock by existing stockholders in the public market, or the availability of these shares for sale, could materially and adversely affect the market price of our common stock. In addition, as soon as practicable after the date of this prospectus, we intend to file a registration statement on Form S-8 with the Securities and Exchange Commission covering the shares of common stock reserved for issuance under our stock option plans. Based on shares and options outstanding as of September 30, 2000, approximately 4,736,755 shares of common stock will be reserved for issuance under our stock option plans on the effective date of this offering. On the date 180 days after the effective date of this offering, at least 1,475,864 shares will be subject to immediately exercisable options, based on options outstanding on September 30, 2000. Sales of a large number of these shares could have an adverse effect on the market price for our common stock. After this offering, the holders of 20,738,045 shares of common stock, including shares issuable upon exercise of warrants which will be outstanding immediately after the consummation of this offering, will have certain rights with respect to registration of such shares for sale to the public. If such holders, by exercising their registration rights, cause a large number of securities to be registered and sold in the public market, such sales could have an adverse effect on the market price for our common stock. If we were to include in a company-initiated registration statement shares held by these holders pursuant to the exercise of their registration rights, these sales may have an adverse effect on our ability to raise needed capital. See "Shares Eligible for Future Sale" beginning on page 58 for further details regarding the number of shares eligible for sale in the public market after this offering. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS This prospectus contains forward-looking statements that relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "intend," "potential" or "continue" or the negative of such terms or other comparable terminology. These statements are only predictions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including the risks outlined under "Risk Factors" beginning on page 5 and elsewhere in this prospectus.

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+RISK FACTORS An investment in our common stock involves a high degree of risk. You should consider carefully the following risks and the other information in this prospectus before investing in our common stock. Each of the following risks could seriously harm our business and results of operations. The trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment. Risks Related to Our Business We cannot predict our future results because we have virtually no operating history. We were incorporated in January 1999, and we began offering our i-opener service in November 1999. Given our limited operating history, it will be difficult for you to evaluate our performance. You should consider the uncertainties that we may encounter as an early stage company in a new and rapidly evolving market. These uncertainties include: . market acceptance of Internet appliances; . consumer demand for, and acceptance of, our i-opener service; . our ability to create user-friendly applications and a portal that appeals to consumers; . our ability to contract with content providers who will furnish useful and entertaining information to our users; . our ability to support a large number of users; . our ability to anticipate and adapt to a developing market and to rapidly changing technologies; . our unproven and evolving business model; and . our need to expand significantly our internal resources to support growth of our product and service offerings. If we are not able to address successfully some or all of these uncertainties, we may not be able to expand our business, compete effectively or achieve profitability. Our ability to generate revenues is unproven and we may never achieve profitability. We expect to generate revenues from user fees for our i-opener service and from other sources such as application services, e-commerce, sponsorships and advertising. Many of our potential customers have never purchased Internet service for personal use, used the Internet and e-mail or engaged in e-commerce transactions. We must convince these potential users to sign up for our service and continue to pay a user fee for our i-opener service. Other potential users already pay a monthly fee for Internet access and/or e-mail service, and we must convince these consumers to pay our user fee in addition to their existing fee or to switch from their existing service to our service. In addition, certain online service providers in the Internet industry offer Internet access at little or no cost to the user, which may cause us to lose existing and potential users. Our inability to convince potential users to pay fees for a significant period of time would prevent us from achieving profitability. We currently price our i-opener Internet appliance below our cost and expect to continue to subsidize the purchase price of our appliance for the foreseeable future. At current pricing levels, a new customer must pay monthly fees for our service for a significant period of time before we recover the purchase price subsidy on that customer's appliance. Any reduction in user fee levels due to competitive or other factors could increase significantly the period of time necessary to recoup our purchase price subsidy. Due to our pricing structure and the short period of time we have been offering our i- opener service, we have experienced significant operating losses to date. If we are unable to achieve sufficient revenues from user fees and other sources to cover the subsidies of appliance purchases, we may never become profitable and our business model could fail. We are not profitable and expect to incur future losses and negative cash flow that could cause our stock price to fall. As of December 31, 1999 we had an accumulated deficit of $43.5 million. We expect to continue to spend significant and increasing amounts to subsidize the purchase price of our i-opener Internet appliance. We also expect that sales and marketing, research and development, and general and administrative expenses will increase significantly. From inception through December 31, 1999, we generated only $25,716 in revenues. We will need to generate and sustain dramatically greater revenues from sales of our services if we are to achieve profitability. If we are unable to achieve dramatically greater revenues, our losses will likely continue indefinitely and we may never generate profits. If this occurs, the market price of our common stock could suffer. Our market share and revenues will suffer if we are not able to compete successfully for users. The markets for Internet appliances, consumer portals and Internet access service are intensely competitive, evolving and subject to rapid technological change. These markets are characterized by an increasing number of entrants. We compete for users, and consequently for potential e-commerce and advertising revenue, directly or indirectly, with the following categories of companies: . online service providers, such as AOL, EarthLink and Microsoft; . software platform providers such as Aether Systems and Liberate Technologies; . Internet portals, such as Excite@Home, Lycos and Yahoo!; . manufacturers of other stand alone Internet appliances, such as InfoGear and WebTV; . manufacturers of portable Internet appliances, such as Hewlett Packard and Palm, and cellular telephone and pager manufacturers; and . manufacturers of personal computers, such as Apple, Compaq, Dell, Gateway, Hewlett Packard and IBM. Virtually all of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a substantially larger installed base of customers than we do. In addition, many of our competitors have nationally known brands and have extensive knowledge of our industry. Moreover, our current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address consumer needs or to combine hardware product and service offerings. We expect the intensity of competition in this market to increase in the future. Increased competition is likely to result in price reductions, reduced or negative margins and difficulty in gaining market share. Any of these effects could seriously harm our business. We rely on a single third-party to manufacture our Internet appliance. If the manufacturer fails to deliver our products in a reliable, timely and cost- efficient manner, our business will suffer. We depend on our relationship with Quanta Computer, Incorporated, a manufacturer based in Taiwan, for the production and delivery of our i-opener Internet appliance. Since we do not have direct control over Quanta's workmanship and the quality of its service, we cannot assure you that we will be able to provide consistently reliable products for our users. If Quanta does not produce our products on a timely basis or delivers products of unacceptable quality, that do not meet specifications or are otherwise flawed, we may have to delay product delivery, recall or replace unacceptable products. As a result, we could lose existing and potential users. If Quanta is unable to manufacture our i-opener Internet appliance due to natural disasters, political turmoil or other reasons, or if Quanta refuses to provide its manufacturing services on a timely basis and on commercially acceptable price terms and alternative providers of these services are not available on acceptable terms, our operating expenses could increase significantly, reducing the likelihood of our becoming profitable. If our brand does not achieve the broad recognition necessary to expand and maintain our user base, our revenues may not grow and our financial performance may suffer. We believe that broad recognition and a favorable consumer perception of our products and services is essential to our future success. Our success in promoting and maintaining our brand, or any other brand that we may use in the future, will depend largely on: . the success of our brand-enhancement strategy, including mass marketing and multi-media advertising, promotional programs and public relations activities; . the quality and ease-of-use of our services and applications; and . our success in providing high-quality content accessible from our Internet portal. If we are unsuccessful in establishing or maintaining a favorable image of our products and services, we may not be able to expand our user base. In addition, in order to attract and retain users and to promote and maintain our brand or future brands, we expect to increase substantially our marketing expenditures. If we incur expenses in promoting and maintaining our brands without a corresponding increase in revenue and income, our financial results could be seriously harmed. If we are unsuccessful in obtaining compelling content, or in developing or maintaining relationships with content providers, we may be unable to attract and retain users. We rely on third parties to provide our cached content, including news, weather and relevant local information, on our i-opener portal. In addition, some content provided via links to third-party sites is provided without the contractual agreement of the third party. Our inability to establish or maintain any or all of the relationships with our content providers could put our delivery of quality services in jeopardy. The inability to obtain any of this content could result in delays in the development or delivery of our services and the loss of existing or potential users. Alternatively, contracts or exclusive arrangements with content providers could result in diminished demand for our service, if the content is not appealing to users, inferior in quality or less desirable than content available from other portals or content providers. We will not be able to support increased numbers of users if our network infrastructure is unable to expand to accommodate increased usage. If our network systems cannot be expanded to manage increased demand, or if our systems fail to perform, we could experience: . unanticipated disruptions and reduced quality of service; . decreased user service and satisfaction; or . delays in the introduction of new applications and services. Any of these results could impair our reputation, damage our brand and result in decreased revenues. If the number of users of our service increases substantially, we will need to expand significantly and upgrade our technology, transaction processing systems and network infrastructure. We do not know whether we will be able to project accurately the rate or timing of any such increases in usage, or expand and upgrade our systems and infrastructure to accommodate such increases in a timely manner. In the event we do not have the required systems and infrastructure to accommodate increased usage of our services, we will have to contract for additional capacity. We cannot assure you that we will be able to contract for additional capacity on terms acceptable to us, if at all. Our systems may fail and consequently our business may suffer. Our ability to facilitate transactions successfully and provide high-quality customer service also depends on the efficient and uninterrupted operation of our computer and communications hardware systems. Our systems and operations also are vulnerable to damage or interruption from human error, natural disasters, power loss, telecommunication failures, break-ins, sabotage, computer viruses, intentional acts of vandalism and similar events. While we currently maintain redundant servers to provide limited service during system disruptions, we do not have fully redundant systems, a formal disaster recovery plan or alternative providers of hosting services. In addition, we do not carry any business interruption insurance to compensate us for any losses that may occur. Any system failure that causes an interruption in service or decreases the responsiveness of our services could impair our reputation, damage our brand name and consequently reduce our revenues. We are dependent upon our telecommunications carrier to provide Internet access to our users; if they fail to provide quality service, we may be unable to retain users. Since we do not have direct control over the reliability of our carrier's network or the quality of its service, we cannot assure you that we will be able to provide consistently reliable Internet access for our users. If the quality of service provided by our telecommunications carrier does not meet our clients' expectations, we may lose users because of dissatisfaction with our service. We will not be able to expand our business if we fail to attract and retain key personnel. Our future success depends on our continuing ability to attract, hire, train and retain a substantial number of highly skilled personnel and on the continued service and performance of our senior management and other key personnel, especially our Chief Executive Officer and Chairman of the Board. The loss of the services of our executive officers or other key employees could adversely affect our business. In addition, we will need to add a significant number of new technical support and operations personnel to develop and maintain the operations of our services. Our facilities are located in Austin, Texas, which has a high demand for technical and other personnel and a relatively low unemployment rate. Competition for qualified personnel in this area is intense, and we may fail to attract or retain the employees necessary to execute our business model successfully. Rapid technological change could render our products and services obsolete. The Internet and the e-commerce industries are characterized by rapid technological innovation, sudden changes in user and customer requirements and preferences, frequent new product and service introductions and the emergence of new industry standards and practices. Each of these characteristics could render our services, products, intellectual property and systems obsolete. The rapid evolution of our market will require that we improve continually the performance, features and reliability of our products and services, particularly in response to competitive offerings. Our success also will depend, in part, on our ability: . to develop or license new products, services and technology that address the varied needs of our customers and prospective customers; and . to respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis. If we are unable, for technical, financial, legal or other reasons, to adapt in a timely manner to changing market conditions or user preferences, we could lose users, which would cause a decrease in our revenue. We may be unable to obtain the additional capital required to grow our business, which could seriously harm our business. If we raise additional funds, you may suffer substantial dilution. We expect that the net proceeds from this offering and cash on hand will meet our working capital and capital expenditure needs for at least the next 12 months. After that time, we may need to raise additional funds, and we cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. Our future capital requirements will depend upon several factors, including the rate of market acceptance of our products and services, our ability to expand our user base, our level of expenditures for sales and marketing and the cost of product and service upgrades. If our capital requirements vary materially from those currently planned, we may require additional financing sooner than anticipated. If we cannot raise funds on acceptable terms, we may not be able to develop our products and services, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which could have a material adverse effect on our ability to grow our business. Further, if we issue equity securities, you will experience dilution of your ownership percentage, and the new equity securities may have rights, preferences or privileges senior to those of our common stock. We may not be able to compete effectively if we are not able to protect our intellectual property. We rely on a combination of trademark, trade secret and copyright law and contractual restrictions to protect our intellectual property. We have applied to register several trademarks, including Netpliance and i-opener, in the United States. We have not yet attempted to register other marks that may become important to us in the future, and none of our marks has been registered in any other country. We have several United States patent applications currently pending. If we are not successful in obtaining the patent protection we seek, our competitors may be able to replicate our technology and compete more effectively against us. The legal protections described above would afford only limited protection. Unauthorized parties may attempt to copy aspects of our products, services, or otherwise attempt to obtain and use our intellectual property. Enforcement of trademark rights against unauthorized use, particularly over the Internet and in other countries, may be impractical or impossible and could generate confusion and diminish the value of those rights. Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of the proprietary rights of others. Any litigation could result in substantial costs and diversion of our resources and could seriously harm our business and operating results. In addition, our inability to protect our intellectual property may harm our business and financial prospects. Also, if we cannot protect our domain names and prevent others from using similar domain names or trademarks, we may not be able to establish a strong brand and our business and financial results could suffer. Our products and services employ technology that may infringe on the proprietary rights of others, and we may be liable to others for significant damages. We believe there is an increasing amount of litigation in the Internet industry regarding intellectual property rights. It is possible that third parties may in the future claim that we or our products or services infringe upon their intellectual property rights. We expect that developers and providers of Internet appliances and similar devices, and providers of Internet access and content services, will be subject to an increasing number of infringement claims as the number of products, services and competitors in our market grows. Any claim, with or without merit, could consume management time, result in costly litigation, cause delays in implementation of our products or services or require us to enter into royalty or licensing agreements. Royalty or licensing agreements, if required and available, may be on terms unacceptable to us or detrimental to our business. Moreover, a successful claim of product infringement against us or our failure or inability to license the infringed or similar technology on commercially reasonable terms could seriously harm our business. We may incur potential product liability for our i-opener Internet appliance and for products sold over the Internet. To date, we have had limited experience in selling our i-opener Internet appliance. In addition, we have had limited experience in selling products over the Internet and developing relationships with manufacturers or suppliers of those products. We plan to enter into relationships with manufacturers or suppliers to offer their products directly through our Internet service. Such a strategy involves numerous risks and uncertainties. Although our agreements with manufacturers and suppliers may sometimes contain provisions intended to limit our exposure to liability claims, these limitations may not prevent our exposure to all potential claims. Liability claims could require us to spend significant time and money in litigation or to pay significant damages. As a result, any such claims, whether or not successful, could seriously damage our reputation and our business. If we expand our business internationally, our business would become increasingly susceptible to numerous international business risks. Although we have not had international sales and subscription fee revenue to date, we intend to initiate international sales efforts. International sales and subscription fees are subject to inherent risks, including: . unexpected changes in international regulatory requirements and tariffs; . difficulties in staffing and managing foreign operations; . longer payment cycles; . greater difficulty in accounts receivable collection; . potentially adverse tax consequences; . price controls or other restrictions on foreign currency; and . difficulties in obtaining export and import licenses. To the extent our dependence on revenues from international sales and subscription fees increases, a material adverse effect on our international business could materially and adversely affect our overall business, operating results and financial condition. Risks Related to Our Industry The market for Internet appliances is new and may not develop as we anticipate. Because the Internet appliance market is new and evolving, the potential size of this market opportunity and the timing of its development are uncertain. Broad acceptance of Internet appliances will depend on many factors. These factors include: . the willingness of large numbers of consumers to use devices other than personal computers to access the Internet; and . the development of content and applications that are accessible from Internet appliances. If the market for Internet appliances does not develop or develops more slowly than we anticipate, our revenues will not grow as quickly as we anticipate, if at all. If Internet use does not continue to increase, we may not be able to expand our business and increase our revenues. Use of the Internet has grown dramatically, but we cannot assure you that Internet use will continue to grow at the same rate, or at all. Substantially all of our revenue is dependent on the continued growth in use of the Internet. A decrease in the demand for Internet services or a reduction in the anticipated growth for such services may prevent us from expanding our business and increasing our revenue. We could face liability for content retrieved through our Internet portal. As a distributor of Internet content, we face potential liability for defamation, negligence, copyright, patent or trademark infringement and other claims based upon the nature and content of the materials that we distribute. Although we carry general liability insurance, our insurance may not cover claims of this type or may not be adequate to indemnify us for all liability that we may suffer. Any of these claims, particularly those resulting in liability that is not covered by insurance or is in excess of insurance coverage, could occupy significant amounts of our management's time and attention, harm our reputation and negatively affect our business. We could be exposed to liability or increased costs if new case law is decided, or new government regulation is enacted, regarding the Internet. The law relating to our business and operations is evolving and no clear legal precedents have been established. The adoption of any new Internet laws and regulations or the application of existing laws and regulations to the Internet and e-commerce may decrease the growth in the use of the Internet. For example, tax authorities in a number of states are currently reviewing the appropriate tax treatment of companies engaged in e-commerce, and new state tax regulations may subject us to additional state sales or other taxes. These results could decrease the demand for our products and services or increase the cost of doing business, either of which would reduce our revenue or profitability. In addition, the applicability to the Internet of existing laws in various jurisdictions governing issues such as property ownership, sales and other taxes, libel and personal privacy is uncertain and may take years to resolve. If we were alleged to have violated federal, state or foreign civil or criminal law, even if we could successfully defend such claims, it could occupy significant amounts of management's time, harm our business reputation and negatively affect our operating results and financial condition. Concerns regarding the security of transmission of confidential information over the Internet may reduce consumer confidence in our product and service offerings and negatively impact our business. The secure transmission of confidential information over the Internet is essential to maintaining user confidence in our Internet service. Substantial or ongoing security breaches on our system or other Internet-based systems could significantly damage user confidence and harm our business. A party that is able to circumvent our security systems could steal proprietary information or cause interruptions in our operations. Security breaches also could damage our reputation and expose us to a risk of loss or litigation and possible liability. Our insurance policies carry low coverage limits, which may not be adequate to reimburse us for losses caused by security breaches. While we attempt to protect against and remedy security breaches, we cannot guarantee that our security measures will prevent security breaches. We also face risks associated with security breaches affecting third parties conducting business over the Internet. Any publicized security problems relating to third parties could heighten concern regarding security and privacy on the Internet, inhibit the growth of the Internet and, therefore, our Internet service as a means of conducting commercial transactions. Risks Related to this Offering You may not be able to sell your stock for the same price or a price higher than you paid when you want to sell it if a public market does not exist for our stock. An active public market for our common stock may not develop or be sustained after this offering. The market price for our common stock will vary from the initial offering price. The market price of our common stock may fluctuate significantly in response to a number of factors, some of which are beyond our control, including: . variations in quarterly operating results; . changes in estimates of our financial performance by securities analysts; . changes in market valuations of comparable Internet-related companies; . announcements by us or our competitors of new products, services, significant contracts, acquisitions, strategic relationships, joint ventures or capital commitments; . our inability to locate or maintain suppliers of our manufactured products at prices that will allow us to attain profitability; . product or design flaws, product recalls or similar occurrences; . loss of a major content provider; . network outages; . loss of our telecommunications provider; . additions or departures of key personnel; . sales of common stock in the future; and . fluctuations in stock market prices and volume, which are particularly common among highly volatile Internet-related securities. We will determine the initial public offering price of the shares of our common stock through negotiations with the underwriters, and this price may not be indicative of the price that will prevail in the trading market. Future sales by current stockholders may depress our stock price. The market price of our common stock could decline as a result of sales of a large number of shares in the market after this offering or the perception that such sales could occur. These factors also could make it more difficult for us to raise funds through future offerings of common stock. There will be 60,435,935 shares of common stock outstanding immediately after this offering. The 8,000,000 shares sold in this offering will immediately be transferable without restriction in the public market, unless these shares are held by affiliates. 190,254 shares will become eligible for sale 90 days after the date of this prospectus. The holders of an additional 51,629,178 shares are subject to agreements with the underwriters or us that restrict their ability to transfer their stock for 180 days after the date of this prospectus without consent of the underwriters or us. After these agreements expire, 34,451,757 additional shares will be eligible for immediate sale in the public market subject to restrictions pursuant to Rule 144. See "Shares Eligible for Future Sale." Our stockholders could be adversely affected if our management and larger stockholders use their influence in a manner adverse to our stockholders' interests. On completion of this offering, our executive officers, directors and 5% stockholders will beneficially own, in the aggregate, approximately 54.7% of our outstanding common stock. As a result, these stockholders will be able to exercise significant control over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, which could delay or prevent someone from acquiring or merging with us. These stockholders may use their influence to approve or take actions which are adverse to your interests. See "Principal Stockholders." You will experience immediate and substantial dilution. The initial public offering price is expected to be substantially higher than the book value per share of the outstanding common stock immediately after the offering. Accordingly, if you purchase common stock in the offering, you will incur immediate dilution in the book value per share of the common stock from the price you pay for the common stock. This dilution will be approximately $12.79 per share, at the initial public offering price of $16.00. In addition, we have issued options to acquire common stock at prices significantly below the assumed initial public offering price. To the extent outstanding options are ultimately exercised, there will be further dilution to investors. For a discussion regarding dilution in this offering, see "Dilution." Some shares in this offering may have been offered or sold in violation of the Securities Act. Prior to the effectiveness of the registration statement covering the shares of our common stock being sold in this offering, Donaldson, Lufkin & Jenrette Securities Corporation, an underwriter of this offering, provided written materials to approximately 200 individuals that we had designated as potential purchasers of up to 400,000 shares of common stock in this offering through a directed share program. These materials may constitute a prospectus that does not meet the requirements of the Securities Act of 1933. No individual who received these written materials should rely upon them in any manner in making a decision whether to purchase shares of common stock in this offering. If the distribution of these materials by Donaldson, Lufkin & Jenrette Securities Corporation did constitute a violation of the Securities Act of 1933, the recipients of these materials who purchased common stock in this offering would have the right, for a period of one year after the date of their purchase of common stock, to obtain recovery of the purchase price paid for their common stock, or, if they had already sold the stock, sue us for damages resulting from their purchase of the common stock. Assuming that these recipients do not acquire additional shares through the underwriters in the offering, these damages would total up to approximately $6.4 million plus interest, based upon the initial public offering price of $16.00 per share, if these investors seek recovery or damages after an entire loss of their investment. To the extent that any of the recipients of the materials also purchase shares through the underwriters in this offering outside the directed share program, the potential damages would increase by $16.00 per share so purchased. We have no way of knowing how many, if any, additional shares of common stock will be purchased by these recipients through the underwriters outside the directed share program, but we believe that the number will not be significant. If these recipients seek recovery or damages, our business, results of operations and financial condition would be harmed. If our management does not effectively use the proceeds from this offering, we may not be able to successfully operate and grow our business. We do not have specific uses planned for the net proceeds of this offering. The net proceeds of this offering will be available for working capital, general corporate purposes and other operating expenses. We believe we need to retain flexibility to respond to factors affecting our business in determining the amount, if any, of these expenditures among our several priorities. Accordingly, our management will retain broad discretion as to the allocation of the proceeds of this offering and may use such proceeds in a manner with which you may not agree. See "Use of Proceeds."

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+RISK FACTORS <PAGE> You should carefully consider the following risks and the other information contained in this prospectus before investing in our common stock. The value of our common stock could decline due to any of these risks, and you could lose all or part of your investment. You also should refer to the other information included in this prospectus, including the financial statements and related notes. The risks described below are not the only ones facing us. We have only described the risks we consider to be material. However, there may be additional risks that we view as not material or of which we are not presently aware. If any of the events described below were to occur, our business, prospects, financial condition, results of operations, or cash flow could be materially adversely affected. When we state below that something could or will have a material adverse effect on us, we mean that it could or will have one or more of these effects. MANAGEMENT RISKS MANAGEMENT OF THE COMPANY IS ALSO RESPONSIBLE FOR MANAGING THE MGS GROUP AND SUCH SHARED MANAGEMENT COULD RESULT IN CONFLICTS OF INTEREST. We rely on executive officers who are also full-time employees of companies in the MGS Group. This shared management may result in conflicts of interest and may compromise our potential as an individual company. Actions by shared management may, for example, result in a benefit to one of the companies in the MGS Group and a corresponding or related detriment to us. We have entered into management agreements with three members of the MGS Group which provide for the payment of fees equal to a total of 5% of our net sales through December, 2006. We have also entered into various leases and other contractual agreements with the MGS Group. As a result of this shared management, our officers are unable to devote their full time and efforts to our management. In addition, our directors also serve as directors of one or more of the companies in the MGS Group and will therefore be responsible not only to our stockholders, but to the stockholders or partners of the MGS Group companies for which they also serve as directors or partners. None of our directors will be independent of the MGS Group. No independent director will evaluate any issues involving potential conflicts of interest between our interests and those of our stockholders, on the one hand, and the interests of the MGS Group and the stockholders or partners of its companies, on the other. 6 See "Business," "The MGS Group," and "Related Party Transactions and Conflicts of Interest." THE LOSS OF THE SERVICES OF MARK G. SELLERS OR OTHER KEY EMPLOYEES MAY REDUCE OUR REVENUES AND IMPAIR OUR PROFITABILITY OR CASH FLOW. We are highly dependent upon our founder, Chairman, President and Chief Executive Officer, Mark G. Sellers. The reduction or loss of the services of Mr. Sellers may have a material adverse effect on our <PAGE> operating results and prospects by reducing our revenues and cash flow and our ability to maintain our business. Mr. Sellers is widely known in the plastics industry and his knowledge of the moldmaking process and plastics industry, business contacts, and leadership have been, and will continue to be, critical to our success. Mr. Sellers has no employment agreement with the Company. Our future continued success also is dependent upon the retention of other of our key management executives. We also depend upon a number of other key employees who have been instrumental in our success thus far, and will depend upon our ability to attract and retain other highly capable individuals. The loss of one or more of these senior executives or key members of our production and quality control staff, or an inability to attract or retain other key individuals, could have a material adverse effect on our business. We seek to compensate our key executives, as well as other employees, through competitive salaries and the opportunity to purchase our stock, but we can make no assurance that these programs will allow us to retain key employees or hire new employees. WE MAY INCUR INCREASED COSTS TO OBTAIN NECESSARY TECHNOLOGICAL, FINANCIAL AND ADMINISTRATIVE SERVICES AFTER OUR AGREEMENTS WITH THE MGS GROUP EXPIRES. Various MGS Group companies provide us with selected administrative, financial reporting, tax, information system, and human resources services. Executive management and marketing services are provided to us under management agreements with MGS Group companies. In order to continue to operate, we will need to maintain the management agreements with the MGS Group after their December 31, 2006 termination date and continue to receive the other services or develop the capability to provide these services internally. If our management agreements are not renewed, or the other services are no longer provided, we may not be able to develop these services at comparable costs after expiration of these agreements. 7 THERE ARE RISKS ASSOCIATED WITH OUR INDUSTRY AND, IN PARTICULAR, OUR BUSINESS WE ARE DEPENDENT ON THE MGS GROUP FOR THE DEVELOPMENT AND RETENTION OF OUR BUSINESS. Our operations are substantially dependent upon companies over which we do not exercise direct control. We have been and will continue to be dependent on the MGS Group to a significant degree for marketing, technical, and manufacturing support. We are currently dependent on the sales and marketing efforts of the companies within the MGS Group to obtain purchase orders and we rely on the resources of the MGS Group for technical and manufacturing support. LONG-TERM CONTRACTS ARE NOT TYPICAL IN OUR INDUSTRY AND REDUCTIONS, CANCELLATIONS, OR DELAYS IN CUSTOMER ORDERS WOULD REDUCE OUR REVENUES AND PROFITABILITY. As is typical in the plastics manufacturing industry, we do not <PAGE> obtain long-term contracts or commitments from our customers. Instead, we work closely with customers to develop nonbinding forecasts of the future volume of orders and rely on purchase orders. Customers may cancel their orders, change production quantities from forecast volumes, or delay production for a number of reasons beyond our control. Significant or numerous cancellations, reductions, or delays in orders by customers would materially decrease our revenue and cash flow and impair our financial condition. In addition, because many of our costs are fixed, a reduction in customer demand could materially lower our gross profit margins and operating income. TERMINATION OF OUR RELATIONSHIP WITH MOTOROLA, INC. WOULD MATERIALLY REDUCE OUR REVENUE AND CAUSE A CORRESPONDING MATERIAL DECREASE IN OUR CASH FLOW AND OPERATING RESULTS. In 1999, we received approximately 56% of our manufacturing revenue from our relationship with six divisions of Motorola, Inc. to produce plastic parts for its cellular telephones and pagers. If Motorola was to experience a significant downturn in its cellular telephone or pager businesses, was otherwise unable to honor its obligations to us, or chose to contract with additional manufacturers, our business would be disrupted and our revenues, cash flow, and liquidity would materially decrease. In addition, such a loss in revenue would result in a material decrease in our operating margin because of our fixed costs. 8 TERMINATION OF OUR RELATIONSHIP WITH ITW PASLODE CORDLESS TOOL GROUP WOULD MATERIALLY REDUCE OUR REVENUE AND CAUSE A CORRESPONDING DECREASE IN OUR CASH FLOW AND OPERATING RESULTS. We have a five-year agreement with ITW Paslode, Cordless Tool Group, a division of Illinois Tool Works, Inc. to supply plastic components. We will occupy a portion of the Paslode facility without direct rent expense as part of the agreement. We expect that sales to Paslode under the agreement will exceed 10% of our revenue in fiscal 2000. The early termination of this agreement would materially reduce our revenues, cash flow and liquidity. In addition, such a loss in revenue would result in a material decrease in our operating margin because of our fixed costs. A DECREASE IN THE BUSINESS OF THE MGS GROUP WOULD MATERIALLY REDUCE OUR REVENUE AND CAUSE A CORRESPONDING MATERIAL DECREASE IN OUR CASH FLOW AND OPERATING RESULTS. Sales to MGS Group companies represented approximately 22.6% of our revenue in 1999. A decrease in the MGS Group's business and, accordingly, a reduction in our sales to MGS Group companies, would materially reduce our revenues, cash flow and profitability. In addition, such a loss in revenue would result in a material decrease in our operating margin because of our fixed costs. WE ARE ENGAGED IN A LEGAL DISPUTE OVER THE ENFORCEABILITY OF A LEASE WHICH COULD RESULT IN A MATERIAL LIABILITY FOR RENT IF THE COURT FINDS IN FAVOR OF THE LANDLORD. In November, 1999, we entered into a lease with an unrelated third party for a 142,000 square foot building in Fort Worth, Texas. <PAGE> We are the plaintiff in a lawsuit which seeks a determination by the court that the lease is of no legal effect or, alternatively, has been breached by the landlord. However, litigation is, by its nature, uncertain and if the lease is held to be enforceable and no other tenant is found for the building, it would have a material adverse effect on our financial condition. The lease is for a term of seven years ending December 31, 2006 and provides for annual payments of $366,648, $431,880, $518,436 respectively, over the first three years of the term and annual payments of $518,436 over each of the remaining four years of the term. As the building was not ready or suitable for our occupancy, we believe that our legal position is correct and that a court should find in our favor. In addition, the landlord has a duty under Texas law to mitigate its damages and seek another tenant. See "Business - Legal Proceeding and Other Claims." 9 FAILURE TO DEVELOP NEW OR EXPAND EXISTING PRODUCTION ORDERS WILL IMPAIR OUR ABILITY TO INCREASE REVENUES AND ACHIEVE PROFITABILITY. Our growth, and the extent of any future profitability, depends to a significant degree upon our ability to develop new customer relationships or to expand existing relationships with current customers. We cannot guarantee that new customers will be found, that any such new relationships will be successful when they are in place, or that business with current customers will increase. If these and other programs are not successful, we will not achieve the revenue, growth, net income or liquidity needed to increase the value of the company. COMPETITION IN OUR INDUSTRY MAY HINDER OUR ABILITY TO EXECUTE OUR BUSINESS STRATEGY, ACHIEVE PROFITABILITY, OR MAINTAIN RELATIONSHIPS WITH EXISTING CUSTOMERS. We operate in an industry that is highly competitive, with no single plastics manufacturer having a dominant position. Competition could cause price reductions, reduced profits or losses, or loss of market share, any of which could have a material adverse effect on our business. We compete against numerous other domestic and foreign providers of plastics manufacturing services, some of which are more established in the industry and have substantially greater revenues or resources than we do. Our inability to do any of the following could materially adversely affect our ability to execute our business strategy and develop new customers: <circle> provide technologically advanced manufacturing services; <circle> maintain strict quality standards; <circle> offer geographic flexibility in production and delivery; <circle> respond flexibly and rapidly to customers' design and schedule changes; and <circle> deliver products on a reliable basis at competitive prices. We also face competition from the manufacturing operations of our current and potential customers who are continually evaluating the relative merits of internal manufacturing versus outsourcing. A shift away from outsourcing on behalf of our current or potential customers <PAGE> could materially reduce our revenues, results of operations and financial condition. 10 OUR REVENUES AND INCOME COULD DECLINE DUE TO OVERCAPACITY IN THE PLASTICS INDUSTRY, GENERAL ECONOMIC TRENDS, AND/OR DECLINES IN BUSINESS OR CONSUMER SPENDING. We enter into purchase order contracts with our customers in which we agree to produce plastic parts at a stated price per part. We cannot assure you that the prices we are able to obtain under our purchase orders will not decline in the future. Although our purchase orders are often parts for technical components and are somewhat resistant to economical cycles, many of the industries which we serve and expect to serve are cyclical. Spending for products for which we now produce parts or components may decline during recessionary periods because of the discretionary nature of consumer and business spending. The price which we can obtain in our purchase order contracts could also fall if the plastics manufacturing industry creates excess capacity for plastic parts. This could significantly reduce our cash flow and could have a material adverse effect on our results of operations and our financial condition. RISKS WHICH ARE PARTICULAR TO INTERNATIONAL OPERATIONS COULD MATERIALLY DECREASE OUR REVENUES AND OPERATING MARGINS. Approximately 40% of our revenue in fiscal 1999 was derived from sales outside of the United States. We expect that foreign sales in fiscal 2000 and subsequent years will not exceed 20% of our revenue. A significant portion of our foreign sales are made to customers who have U.S. operations, but who assemble components or end-use products offshore for sale in the U.S. International sales (and the international operations of our customers) are subject to inherent risks, which may adversely affect us, including: <circle> fluctuations in the value of currencies; <circle> unexpected changes in and the burdens and costs of compliance with a variety of foreign laws; <circle> political and economic instability; <circle> increases in duties and taxation; <circle> limitations on imports or exports; and <circle> reversal of the current policies (including favorable tax and lending policies) encouraging foreign investment or foreign trade by our host countries. 11 CHANGES IN THE COST OR AVAILABILITY OF RAW MATERIALS MAY MATERIALLY REDUCE OUR OPERATING MARGINS AND PROFITABILITY. In turn-key manufacturing, we provide both the equipment and the manufacturing and engineering services. As a result, we often bear the risk of increases in materials costs, scrap, and excess inventory, each of which can adversely affect our gross profit margins and liquidity. We forecast our future needs based upon the anticipated needs of our <PAGE> customers. Inaccuracies in making these forecasts or estimates could result in a shortage or an excess of materials, which could affect production schedules, margins and profitability. Some of the products we manufacture require particular types of plastic. Supply shortages for a particular type of plastic can delay production or cause cost increases in the services we provide. WE WILL NEED ADDITIONAL FINANCING WHICH MAY NOT BE AVAILABLE, OR WHICH MAY DILUTE THE OWNERSHIP INTERESTS OF INVESTORS. We have limited funds. In order to fully implement the growth in our business which is anticipated by our fiscal 2000 and 2001 business plans we will need the proceeds of the offering and additional debt financing. Our fiscal year 2000 business plan anticipates the sale of 500,000 shares in the offering and additional debt financing of $2 to $5 million. If we cannot sell 500,000 shares, or if we cannot obtain all of this additional financing, implementation of our 2000 business plan will be delayed. In addition, we anticipate that we will need to raise approximately $7 million in additional capital through the issuance of additional securities or additional borrowings in order to implement our business plan for fiscal year 2001. The risk that we may not sell all of the common stock in the offering and the risk that we may not be able to raise sufficient additional funds through borrowings or the sale of additional securities are, to some degree, interrelated. These risks are discussed under the following subheadings. WE MAY NOT BE ABLE TO SELL ALL OF THE COMMON STOCK IN THIS OFFERING AND MAY NEED TO BORROW ADDITIONAL FUNDS IN ORDER TO MEET OUR OBJECTIVES FOR FISCAL YEAR 2000 OR DELAY IMPLEMENTATION OF OUR BUSINESS PLANS. This offering is not underwritten, there is no minimum number of shares which must be sold before proceeds of the offering are made available to us, and there is no assurance that we will be able to sell all or a substantial portion of the shares being offered. To the extent we are unable to sell 500,000 shares, we will be required to 12 borrow additional funds from commercial lenders or seek financing from the MGS Group in order to realize our fiscal 2000 business expansion plans within the time frame anticipated by our strategic plan. Accordingly, if we do not sell 500,000 shares in the offering, and if we are not able to secure alternative financing to replace the expected proceeds of the offering, our plan to expand our business operations in fiscal years 2000 and 2001 will be delayed for an undetermined period of time. See "Use of Proceeds." WE MAY NOT BE ABLE TO OBTAIN THE ADDITIONAL FINANCING CONTEMPLATED BY OUR BUSINESS PLANS FOR 2000 AND 2001. Even if we are successful in selling all 500,000 shares in the offering, we will need to increase our line of credit by, or secure term debt of, $2 to $5 million in order to meet the working capital needs of our 2000 business plan. In addition, we expect that we will need to raise approximately $7 million in additional capital later in <PAGE> fiscal year 2000 through the sale of additional securities or additional borrowings, or a combination of each, in order to provide funding for our planned expansion in fiscal year 2001. If these funds are not available, implementation of our plans would be delayed or deferred indefinitely. No commitments to provide additional funds have been made by management or other stockholders. We will be seeking additional financing to meet our short-term needs, but we have not investigated the availability, source or terms that might govern additional financing from a bank or other commercial lender to meet our needs with respect to fiscal year 2001. There is no assurance that funds will be available from any source or, if available, that funds can be obtained on terms acceptable to us. Even if commercial financing is available to meet our additional short- or long-term working capital needs, lenders almost always impose restrictions of a type which may limit our operational flexibility in the future. In addition, indebtedness may increase our vulnerability to general adverse economic and industry conditions by limiting our flexibility in planning for and reacting to changes in our business and industry. Typically, lenders would seek to limit our ability, among other things, to: <circle> incur additional indebtedness; <circle> enter into transactions with affiliates; <circle> pay dividends and make distributions; <circle> enter into sale and leaseback transactions; <circle> issue stock of subsidiaries; <circle> make capital expenditures; <circle> make investments; <circle> repurchase stock; 13 <circle> create liens; <circle> merge or consolidate our company; and/or <circle> transfer and sell assets. SUCCESSFUL IMPLEMENTATION OF OUR BUSINESS STRATEGIES DEPENDS ON OUR ABILITY TO SUCCESSFULLY ACQUIRE ADDITIONAL COMPANIES WE MAY NOT BE ABLE TO IDENTIFY, FINANCE, AND CLOSE ANY FUTURE ACQUISITIONS. The acquisition of additional mold makers and injection molding capacity are essential parts of our business strategies. Competition for attractive companies in our industry is substantial. In executing this part of our strategy, we may experience difficulty in identifying suitable acquisition candidates or in completing selected transactions. In addition, current or future credit facilities may restrict our ability to acquire the assets or business of other companies. If we are able to identify acquisition candidates, such acquisitions may be financed with cash or substantial borrowings. The use of cash or borrowings for acquisitions may restrict the cash or borrowings needed to fund other parts of our growth such as additional manufacturing equipment, marketing or training. In addition, we may choose to finance transactions with potentially dilutive issuances of equity <PAGE> securities. WE MAY EXPERIENCE DIFFICULTY IN INTEGRATING ACQUIRED BUSINESSES WHICH MAY INTERRUPT OUR BUSINESS OPERATIONS. The acquisition of additional mold makers and injection molding capacity are essential parts of our business strategies. Acquisitions involve numerous risks, which may adversely affect our ability to operate our business successfully and produce consistent financial results. In addition, during the integration of an acquired company, our financial performance may suffer from disruption of operations and the financial impact of expenses necessary to close the transaction and realize benefits from the acquisition. Some of the risks involved in acquisitions include: <circle> difficulty in integrating operations, technologies, systems, and products and services of acquired companies; <circle> diversion of management's attention and increased demands on our administrative, technical, and financial personnel resources and systems; <circle> increased expenses and working capital requirements; <circle> entering markets in which we have no or limited prior experience and where competitors in such markets have stronger market positions; 14 <circle> potential loss of key employees and customers of acquired companies; and <circle> financial risks, such as <circle> potential liabilities of the acquired businesses; <circle> the dilutive effect of the issuance of additional equity securities; <circle> the incurrence of additional debt; <circle> the financial impact of amortizing or writing off goodwill and other intangible assets involved in any transactions that are accounted for using the purchase method of accounting; and <circle> possible adverse tax and accounting effects. The difficulties of integrating acquired businesses may be further complicated by the geographic distances between facilities. WE HAVE HAD OPERATING LOSSES SINCE THE INCEPTION OF OUR BUSINESS If we are not profitable, the price which other investors may be willing to pay for our common stock would be reduced. As of December 31, 1999, we had an accumulated deficit (unaudited) of $3,314,102. We have had net losses in the two plus years in which we have been in operation. We expect to incur substantial costs in connection with the planned expansion of our business in fiscal 2000 and 2001. If our expansion plans proceed as planned, we do not expect to be profitable in 2000 and only marginally profitable in 2001. We cannot guarantee that we will be profitable in periods after 2001. For a discussion of our results of operations, please turn to "Management's Discussion and Analysis of Financial Condition and Results of Operations." <PAGE> OUR FAILURE, OR THE FAILURE OF OUR SUPPLIERS OR CUSTOMERS, TO ADDRESS INFORMATION TECHNOLOGY ISSUES RELATED TO THE YEAR 2000 COULD RESULT IN THE LOSS OF BUSINESS AND REDUCE OUR REVENUE AND CASH FLOW AND HARM OUR FINANCIAL CONDITION As of the date of this prospectus it appears that neither we, nor our vendors or customers will encounter material year 2000 problems. However, at this time we cannot guarantee that our systems or the systems of the MGS Group or our suppliers and customers will continue to function without year 2000 related problems, or that there will not be significant problems among information technology systems generally. Given the potentially pervasive nature of the year 2000 problem, we cannot guarantee that disruption in other industries and market segments will not adversely affect our business. See "Management's Discussion and Analysis - Year 2000" 15 INVESTMENT RISKS UNDER WISCONSIN LAW, STOCKHOLDERS MAY SHARE A LIABILITY FOR UNPAID WAGES (FOR UP TO SIX MONTHS OF AN EMPLOYEE'S SERVICE); EACH STOCKHOLDER'S LIABILITY IS LIMITED TO THE AMOUNT PAID FOR THE COMMON STOCK. Under Wisconsin law, stockholders of a Wisconsin corporation may be held personally liable in an amount equal to the consideration paid for their shares for amounts owed to employees for past services performed for the company. This potential liability cannot exceed wages for six months' service for any employee. YOUR OWNERSHIP INTERESTS MAY ALSO BE DILUTED IF ADDITIONAL COMMON STOCK IS SOLD. We are likely to consider issuing, and may, in fact, issue, additional equity securities in order to provide funds required to maintain or increase our operations. If we issue additional stock or other equity-related securities, those securities may have rights, preferences or privileges senior to those of the common stock and you may experience a dilution of your ownership interests and investment. Our business plan for the 2001 fiscal year will require approximately $7 million in additional capital and we may raise additional funds to reduce outstanding indebtedness. We may choose to raise all or a portion of these amounts through the sale of securities. The authorized shares of common stock remaining after completion of the offering could be issued by our board of directors for a variety of other corporate purposes, including anticipated future offerings to raise additional capital, future acquisitions of molding facilities or equipment, defenses to unfriendly corporate acquisitions, and stock option and other stock grant plans. WE MAY RETAIN A CONTINGENT LIABILITY IN CONNECTION WITH OUR OFFER TO REPURCHASE COMMON STOCK; AS A RESULT, WE MAY BE UNABLE TO SATISFY OUR FUTURE CAPITAL AND LIQUIDITY REQUIREMENTS. The common stock sold by us and some of the MGS Group companies <PAGE> during the period from August 6, 1999 through September 30, 1999, was not registered under federal and state securities laws. Federal securities laws do not expressly provide that a rescission offer will terminate a purchaser's right to rescind a sale of stock which was not registered as required. If any or all of these stockholders reject the rescission offer, we may continue to be liable under federal securities laws for up to an aggregate amount of approximately $1.95 million plus statutory interest. We are offering to repurchase these shares. Persons who return these shares to us will receive the price they paid for the shares, plus interest from the date of their purchase. If this 16 offer is accepted by all of the purchasers, we could be required to make payments to the holders of these shares of approximately $1.95 million plus statutory interest. We do not expect these stockholders to return their shares. We have a written agreement with Mr. Sellers and the MGS Group that they will assume our obligations to purchase shares which are returned by stockholders who accept our repurchase offer. Accordingly, we do not expect to be required to use a portion of the proceeds from this offering to make any such payments. See "Rescission Offer." YOU MAY NOT BE ABLE TO RESELL YOUR COMMON STOCK, OR MAY HAVE TO SELL IT AT A DISCOUNT, BECAUSE IT IS NOT EXPECTED THAT AN ACTIVE TRADING MARKET WILL BE DEVELOPED OR MAINTAINED. No public market currently exists for our common stock. It is not expected that a market for the common stock will develop or be maintained following this offering. As a result, you may not be able to sell your shares of common stock or may have to sell them at a discount. THE PRICE OF OUR COMMON STOCK COULD FLUCTUATE SUBSTANTIALLY. The value of our common stock will be affected by the limited ability of investors to buy or sell our common stock, other business developments, and sales by other persons. In the absence of an active market, you can expect only limited and sporadic transactions in our stock. Any such transactions will not be publicly reported. In addition to the effects that this lack of liquidity may have, we believe that the market value of our common stock will also be affected by a number of factors, both within and outside our control. Some of these additional factors that could affect the market value of our common stock include: <circle> announcements of developments related to our business or our competitors' or customers' businesses; <circle> loss or cancellation of material purchase orders with our customers; <circle> fluctuations in our financial results; <circle> general conditions or developments in the plastics business; <circle> potential sales of our common stock by us or our stockholders; and <circle> announcements by third parties of significant claims or proceedings against us. <PAGE> The future sale of a substantial number of shares of common stock, or the perception that future sales could occur, could result in a material decrease in the future market price of, or interest by investors in, our common stock. Approximately 4,250,000 shares of our 17 common stock will be outstanding after completion of the offering and 5,000,000 additional shares of common stock will be subject to currently exercisable options. All of the common stock to be sold in this offering will be freely tradeable without restriction or further registration under the federal securities laws unless purchased by persons who control the company. The transfer of a total of 2,471,610 shares of outstanding common stock upon completion of the offering will be subject to transfer restrictions under the Securities Act of 1933, representing approximately 58.2% of the outstanding common stock. These securities will be subject to restrictions on the timing, manner and volume of sales. We expect that we will need to raise additional capital through the sale of additional securities later in fiscal year 2000 in order to provide funding for our planned expansion in fiscal year 2001. We cannot predict if future sales of our common stock or the availability of our common stock for sale will reduce the market price for, or interest in, our common stock or our ability to raise capital by offering equity securities. MR. SELLERS WILL CONTROL OUR COMPANY AND THIS CONTROL COULD INHIBIT POTENTIAL CHANGES IN CONTROL OR CONFLICT WITH THOSE OF THE OTHER HOLDERS OF OUR COMMON STOCK. Following the sale of 500,000 shares in this offering, Mr. Sellers, individually and through his direct or indirect ownership of the MGS Group, will beneficially own or control approximately 53% of the voting power of our outstanding common stock. Mr. Sellers, or companies in the MGS Group, also have options to purchase an additional 5,000,000 shares at a price of $10.00 per share. As a result, Mr. Sellers will have the practical ability to control the outcome of all matters requiring stockholder approval, including the election and removal of our entire board of directors, any merger, consolidation, or sale of all or substantially all of our assets, and the ability to control our management and affairs. This concentrated control could discourage others from initiating any potential merger, takeover, or other change in control transaction that other stockholders may consider beneficial. As a result, the market price of our common stock could be materially reduced and its liquidity could be further adversely affected. In addition, the interests of the MGS Group and Mr. Sellers could conflict with the interests of the other holders of the common stock. 18 SOME OF THE PROVISIONS OF OUR CURRENT ARTICLES OF INCORPORATION AND BY- LAWS (AND SOME PROPOSED CHANGES TO THESE DOCUMENTS) COULD DISCOURAGE POTENTIAL ACQUISITION PROPOSALS AND COULD DELAY, DETER OR PREVENT A CHANGE IN CONTROL. Our articles of incorporation and by-laws may have the effect of <PAGE> making it more difficult for a third party to acquire, or could discourage a third party from attempting to acquire, control of the company. For example, we intend to amend our articles of incorporation and by-laws to provide that only one-third of our board of directors is to be elected at each annual meeting of stockholders and to require that two-thirds of the shares be voted for a merger or sale of the company's assets. In addition, stockholders must give advance notice of any intention to nominate a candidate for election as a director or to bring matters before a meeting of stockholders. See "Description of Common Stock." YOU WILL EXPERIENCE IMMEDIATE AND SUBSTANTIAL DILUTION. The price at which we are offering to sell you our common stock is substantially higher than the net tangible book value of each outstanding share. If you purchase common stock in this offering, you will experience immediate and substantial dilution. The dilution will be $9.41 per share in net tangible book value of our common stock from the initial public offering price. If outstanding options to purchase shares of common stock are exercised, there would be further dilution. See "Dilution," "Management," and "Related Party Transactions and Conflicts of Interest" for information regarding outstanding stock options and additional stock options which may be granted. THERE IS NO LIKELIHOOD THAT WE WILL PAY CASH DIVIDENDS ON THE COMMON STOCK FOR THE FORESEEABLE FUTURE. We have never paid a cash dividend on our common stock. It is unlikely that we will pay any cash dividends for the foreseeable future. OUR MANAGEMENT WILL HAVE SUBSTANTIAL DISCRETION OVER THE USE OF THE PROCEEDS FROM THIS OFFERING The net proceeds of our sale of 500,000 shares of common stock in this offering will be approximately $5.85 million, after deducting estimated offering expenses of $150,000. Our management will retain broad discretion as to the use of those proceeds and the funds we intend to borrow. We intend to use a substantial portion of the net proceeds from this offering for working capital needs related to the expansion of our business, and to acquiring additional equipment. The 19 timing of the application of these funds is not fixed and will depend, in part, in our ability to obtain additional financing. The failure of our management to apply these funds effectively could have a material adverse effect on our business, results of operations and financial condition. For more information, see "Use of Proceeds." WE HAVE A SHORT OPERATING HISTORY, WE HAVE NEVER OPERATED AS A PUBLIC COMPANY, AND THE OBLIGATIONS INCIDENT TO BEING A PUBLIC COMPANY WILL REQUIRE ADDITIONAL EXPENDITURES Prior to this offering, we have never been a public company. We expect that the obligations of being a public company, including substantial public reporting obligations, will require significant <PAGE> additional expenditures, place additional demands on our management, and may require the hiring of additional personnel. We were incorporated in 1996 and did not begin plastic manufacturing operations until November, 1997. We have made significant investments in equipment and facilities, personnel additions, and organizational changes, and have experienced significant growth. Accordingly, we have only a limited operating history for potential investors to consider. We will also be required to implement financial reporting systems and other controls which we have not previously used. We may need to implement additional systems in order to adequately function as a public company. Such expenditures could adversely affect our liquidity and general financial condition and the results of our operations. IF WE ARE NOT ABLE TO EFFECTIVELY MANAGE OUR GROWTH, OUR RESULTS OF OPERATIONS, FINANCIAL CONDITION, AND PROSPECTS COULD DECLINE Our rapid growth since 1997 has placed significant demands on our management and other resources. If we continue to experience rapid growth, we will require significant additional investment in personnel, systems, and related capital expenditures. We may not be able to recruit adequate personnel, or properly train, integrate, or manage our growing employee base, implement new systems (including those for transaction processing and operational and financial management), or invest in capital expenditures in a timely and effective manner. If we fail to effectively manage and continue this growth, our results of operations, financial condition, and prospects could decline. 20

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+RISK FACTORS You should carefully consider the following risk factors in addition to the other information contained in this prospectus before purchasing our notes. RISKS RELATED TO OUR SUBSTANTIAL DEBT WE MAY NOT BE ABLE TO SERVICE OUR SUBSTANTIAL DEBT OR OBTAIN ADDITIONAL FUTURE DEBT FINANCING As of December 31, 1999, adjusted for the offering of the senior discount notes and the prepayment of amounts outstanding under the Nortel financing, our outstanding debt totaled $157.2 million. In addition, under our current business plan, we expect to incur substantial additional debt before achieving break-even operating cash flow. Our substantial debt will have a number of important consequences for our operations and our investors, including the following: - we will have to dedicate a substantial portion of any cash flow from operations to the payment of interest on, and principal of, our debt, which will reduce funds available for other purposes; - we may not have sufficient funds to pay interest on, and principal of, our debt; - we may not be able to obtain additional financing for currently unanticipated capital requirements, capital expenditures, working capital requirements and other corporate purposes; and - we may be more highly leveraged than some of our competitors, which may put us at a competitive disadvantage. WE ARE A HOLDING COMPANY AND THE SENIOR DEBT OF OUR SUBSIDIARY GUARANTORS MAY RESTRICT PAYMENT ON THE NOTES The notes are unsecured obligations of Alamosa PCS Holdings, Inc. We are a holding company that derives all operating income from our subsidiaries. We are dependent on the earnings and cash flow of our subsidiaries to meet our obligations with respect to the notes. We cannot assure you that our subsidiaries will be able to, or be permitted to, pay to us amounts necessary to service the notes. The Nortel financing permits our subsidiaries to make distributions with respect to scheduled interest payments on the notes, but only so long as there is not a default under the Nortel financing. The Nortel financing contains financial covenants that our subsidiaries must adhere to in order to avoid a default. The indenture governing the terms of the notes permits our subsidiary guarantors to enter into other agreements that can similarly limit our ability to receive distributions from our subsidiaries. In the event we do not receive distributions from our subsidiaries, we would be unable to make required principal and interest payments on the notes. Although the notes will be guaranteed by our subsidiaries, these guarantees will be unsecured and subordinate in right of payment to all designated senior debt of the subsidiaries. The guarantees will be equal in right of payment to other senior subordinated debt of our subsidiaries. In particular, the guarantees will be subordinate in right of payment to the Nortel financing. As of December 31, 1999, assuming the reorganization of Alamosa into a holding company structure, the subsidiary guarantors would have had approximately $71.9 million outstanding under the Nortel financing. The indenture governing the terms of the notes permits the subsidiary guarantors to incur substantial amounts of additional designated senior debt. In the event of bankruptcy, liquidation or reorganization of our subsidiary guarantors, the assets of the subsidiary guarantors will be available to pay the notes only after all designated senior debt of the subsidiary guarantors has been paid in full. Sufficient funds may not exist to pay amounts due on the notes in such event. Furthermore, the Nortel financing is secured by liens on substantially all of our assets and the assets of our subsidiaries. Therefore, if Alamosa PCS, Inc. were to default on the payment of the Nortel financing, the lenders could foreclose on the collateral that secures the Nortel financing regardless of any default with respect to the notes. If this were to happen, we would be incapable of generating revenue sufficient to pay amounts due on the notes. In addition, the subordination provisions of the indenture governing the notes provide that no cash payment may be made with respect to the subsidiary guarantees during the continuance of a payment default under any designated senior debt of the subsidiary guarantors. Therefore, if we fail to make a required payment in respect of any designated senior debt, including the Nortel financing, we would be unable to make any payments with respect to the subsidiary guarantees. The indenture governing the terms of the notes also provides that Nortel and other lenders can prevent payments under the subsidiary guarantees for up to 180 days in the event there are non-payment defaults under any designated senior debt. For further information on the risks associated with designated senior debt of our subsidiaries, see "-- Risks Particular to Alamosa -- If we do not meet all of the conditions required under our Nortel financing arrangements, we may not be able to draw down all of the funds we anticipate receiving from Nortel and may not be able to complete the build-out of our portion of the Sprint PCS network." THE TERMS OF THESE NOTES WILL PLACE RESTRICTIONS ON US WHICH MAY LIMIT OUR OPERATING FLEXIBILITY. The indenture governing the notes will impose material operating and financial restrictions on us. These restrictions may limit our ability to engage in some transactions, including the following: - designated types of mergers or consolidations; - paying dividends or other distributions to our stockholders; - making investments; - selling assets; - repurchasing our common stock; - changing lines of business; - borrowing additional money; and - transactions with affiliates. These restrictions could limit our ability to obtain debt financing, repurchase stock, refinance or pay principal or interest on our outstanding debt, consummate acquisitions for cash or debt or react to changes in our operating environment. RISKS RELATED TO OUR RELATIONSHIP WITH SPRINT PCS THE TERMINATION OF OUR AFFILIATION AGREEMENTS WITH SPRINT PCS WOULD SEVERELY RESTRICT OUR ABILITY TO CONDUCT OUR BUSINESS Our relationship with Sprint PCS is governed by our affiliation agreements with Sprint PCS. Since we do not own any licenses to operate a wireless network, our business depends on the continued effectiveness of those affiliation agreements. However, Sprint PCS can terminate our affiliation agreements if we materially breach them. Among other things, a failure to meet the build-out requirements for any one of the individual markets in our territory or a failure to meet Sprint PCS's technical or customer service requirements would constitute a material breach of our management agreement with Sprint PCS that could lead to its termination. If Sprint PCS terminates any of our affiliation agreements, we would no longer be a part of the Sprint PCS network and would have extreme difficulty in conducting our business. PROVISIONS OF OUR AFFILIATION AGREEMENTS WITH SPRINT PCS MAY DIMINISH OUR VALUE AND RESTRICT THE SALE OF OUR BUSINESS Under specific circumstances and without further stockholder approval, Sprint PCS may purchase our operating assets or capital stock for 72% or 80%, depending on the circumstances, of the "entire business value" of Alamosa, which value includes the spectrum licenses, business operations and other assets more fully described in "Our Affiliation Agreements with Sprint PCS -- The Management Agreement -- Determination of Entire Business Value." Sprint PCS must approve any change of control of our ownership and consent to any assignment of our affiliation agreements with them. In addition, Sprint PCS has a right of first refusal if we decide to sell our operating assets to a third party. We are also subject to a number of restrictions on the transfer of our business, including a prohibition on the sale of Alamosa or our operating assets to competitors of Sprint or Sprint PCS. These restrictions and other restrictions in our affiliation agreements with Sprint PCS may limit our ability to sell the business, may reduce the value a buyer would be willing to pay for our business and may reduce the "entire business value" of Alamosa. SPRINT PCS MAY MAKE DECISIONS THAT COULD INCREASE OUR EXPENSES, REDUCE OUR REVENUES OR MAKE OUR AFFILIATE RELATIONSHIP WITH THEM LESS COMPETITIVE Sprint PCS, under our affiliation agreements with them, has a substantial amount of control over the conduct of our business. Accordingly, Sprint PCS may make decisions that adversely affect our business, such as the following: - Sprint PCS prices its national plans based on its own objectives and could set price levels that may not be economically sufficient for our business. - Sprint PCS could change the per minute rate for Sprint PCS roaming fees and increase the costs for Sprint PCS to perform back office services. - Sprint PCS could withhold its consent, which is required for us to sell non-Sprint PCS approved equipment. - Sprint PCS may alter its network and technical requirements or request that we build-out additional areas within our territory, which could result in increased equipment and build-out costs or in Sprint PCS building-out that area itself or assigning it to another affiliate. A CHANGE OF CONTROL OF SPRINT OR SPRINT PCS MAY RESULT IN A NAME CHANGE OR COULD INCREASE THE LIKELIHOOD THAT OUR AFFILIATION AGREEMENTS WILL NOT BE RENEWED Sprint or Sprint PCS may experience a change of control, sale or merger that could adversely affect our relationships with them or result in a name change. MCI WorldCom Inc. and Sprint have announced a proposed merger in which owners of each class of Sprint's common stock would exchange their Sprint stock for MCI common stock. If the merger is completed, we expect that our affiliation agreements with the merged company would be on the same terms as our current affiliation agreements with Sprint PCS. However, the consummation of the merger may increase the likelihood that our affiliation agreements will not be renewed if, among other things, the combined company has a different strategy related to affiliate relationships. Additionally, we may lose the use of the recognizable Sprint and Sprint PCS brand names if the merger results in a name change. PROBLEMS EXPERIENCED BY SPRINT PCS WITH ITS INTERNAL SUPPORT SYSTEMS COULD LEAD TO CUSTOMER DISSATISFACTION OR INCREASE OUR COSTS We rely on Sprint PCS's internal support systems, including customer care, billing and back-office support. As Sprint PCS has expanded, its internal support systems have been subject to increased demand and, in some cases, suffered a degradation in service. We cannot assure you that Sprint PCS will be able to successfully add system capacity or that its internal support systems will be adequate. It is likely that problems with Sprint PCS's internal support systems could cause: - delays or problems in our own operations or service; - delays or difficulty in gaining access to customer and financial information, which we are currently experiencing with respect to our direct electronic access to significant aspects of Sprint PCS's internal support systems and financial data; - a loss of Sprint PCS customers; and - an increase in the costs of customer care, billing and back office services. OUR COSTS FOR INTERNAL SUPPORT SYSTEMS MAY INCREASE IF SPRINT PCS TERMINATES OUR SERVICES AGREEMENT We estimate that our costs for the services provided to us by Sprint PCS under our services agreement in the year 2000 will be approximately $12 million. We expect this number to significantly increase as the number of Sprint PCS subscribers based in our territory increases. Our services agreement with Sprint PCS provides that, upon nine months' prior written notice, Sprint PCS may terminate any service provided under that agreement. We do not have a contingency plan if Sprint PCS terminates any such service. If Sprint PCS terminates a service for which we have not developed a cost-effective alternative or increases the amount it charges us for these services, our operating costs may increase beyond our expectations and our operations may be interrupted or restricted. WE MAY HAVE DIFFICULTY IN OBTAINING HANDSETS AND EQUIPMENT, WHICH ARE IN SHORT SUPPLY We depend on our relationship with Sprint PCS to obtain handsets and equipment. The demand for the equipment we require to construct our portion of the Sprint PCS network is considerable, and manufacturers of this equipment have substantial order backlogs. In addition, the demand for specific types of handsets is strong and the manufacturers of those handsets may have to distribute their limited supply of products among the manufacturers' numerous customers. If Sprint PCS modifies its handset logistics and delivery plan or if we are not able to continue to rely on Sprint PCS's relationships with suppliers and vendors, some of which provide us with vendor discounts on equipment, we could have difficulty obtaining specific types of handsets and equipment in a timely manner and our equipment costs would increase. As a result, we could suffer delays in the build-out of our portion of the Sprint PCS network, disruptions in service and a reduction in subscribers. IF WE FAIL TO PAY OUR DEBT, OUR LENDERS MAY SELL OUR LOANS TO SPRINT PCS AND GIVE SPRINT PCS RIGHTS OF A CREDITOR TO FORECLOSE ON OUR ASSETS Sprint PCS has contractual rights to purchase Nortel's rights as a senior lender under the Nortel financing documents. These rights are triggered by an acceleration of the maturity of the Nortel financing. To the extent Sprint PCS purchases these obligations, Sprint PCS's interests as a creditor could conflict with ours. Sprint PCS's rights as a lender that is senior to the holders of the notes would enable it to exercise rights with respect to our assets, including the right to foreclose on those assets, in a manner not otherwise permitted under our affiliation agreements with Sprint PCS and in conflict with the interests of the holders of the notes. IF SPRINT PCS DOES NOT MAINTAIN CONTROL OVER ITS LICENSED SPECTRUM, OUR AFFILIATION AGREEMENTS WITH SPRINT PCS MAY BE TERMINATED Sprint PCS, not Alamosa, owns the licenses necessary to provide wireless services in our territory. The Federal Communications Commission requires that licensees like Sprint PCS maintain control of their licensed systems and not delegate control to third party operators or managers like Alamosa. Although our affiliation agreements with Sprint PCS reflect an arrangement that the parties believe meets the Federal Communications Commission requirements for licensee control of licensed spectrum, we cannot assure you that the Federal Communications Commission will agree with us. If the Federal Communications Commission were to determine that our affiliation agreements with Sprint PCS need to be modified to increase the level of licensee control, we have agreed with Sprint PCS to use our best efforts to modify the agreements to comply with applicable law. If we cannot agree with Sprint PCS to modify the agreements, they may be terminated. If the agreements are terminated, we would no longer be a part of the Sprint PCS network, and we would have extreme difficulty conducting our business. THE FEDERAL COMMUNICATIONS COMMISSION MAY NOT RENEW THE SPRINT PCS LICENSES, WHICH WOULD PREVENT US FROM PROVIDING WIRELESS SERVICES We do not own any licenses to operate a wireless network. We are dependent on Sprint PCS's licenses, which are subject to renewal and revocation. Sprint PCS's licenses in our territory will expire in 2005 or 2007 but may be renewed for additional ten-year terms. The Federal Communications Commission has adopted specific standards that apply to wireless personal communications services license renewals. Any failure by Sprint PCS or us to comply with these standards could cause revocation or forfeiture of the Sprint PCS licenses for our territory. Additionally, if Sprint PCS does not demonstrate to the Federal Communications Commission that Sprint PCS has met the five-year and ten-year construction requirements for each of its wireless personal communications services licenses, it can lose those licenses. If Sprint PCS loses its licenses in our territory for any of these reasons, we would not be able to provide wireless services without obtaining rights to other licenses. RISKS PARTICULAR TO ALAMOSA'S OPERATIONS BECAUSE OF THE NATURE OF OUR RELATIONSHIP WITH CHR SOLUTIONS, INC., ANY CONFLICTS THAT ARISE BETWEEN US AND CHR SOLUTIONS COULD NEGATIVELY AFFECT OUR ABILITY TO EFFECTIVELY CONDUCT OUR BUSINESS We rely heavily on CHR Solutions, Inc. for engineering, marketing, operating and other consulting services. We have paid or will pay CHR Solutions substantial amounts for these services, including approximately: - $3.8 million paid during 1999; - $3.5 million that we estimate will be paid during 2000; - an aggregate of $7.4 million in current and prior contractual commitments beginning in 1998; and - an anticipated additional $5 million in contractual commitments that we are currently negotiating with CHR Solutions. If CHR Solutions interests become adverse to ours, we may be forced to acquire consulting services from an alternate source, which could be very difficult or costly or result in delays in our network build-out. Additionally, Mr. David Sharbutt, our chairman and chief executive officer, is also a senior consultant, director and shareholder of CHR Solutions. Consequently, if CHR Solution's interests become adverse to ours, Mr. Sharbutt may face a conflict of interest. In addition, although the employment agreement related to Mr. Sharbutt's position as a senior consultant of CHR Solutions does not specify the time requirements of his employment, his responsibilities as an employee of CHR Solutions may require significant professional time and effort and may reduce the time and effort he devotes to Alamosa. However, his employment agreement with us requires Mr. Sharbutt to devote his full time and effort to the business and affairs of Alamosa. See "Certain Relationships and Related Transactions" for details related to this and other related party transactions. OUR STOCKHOLDERS, MEMBERS OF MANAGEMENT AND DIRECTORS MAY BE SUBJECT TO CONFLICTS OF INTEREST Some of our stockholders and members of management have significant investments in communications services companies that compete with Alamosa. In addition, several of our directors serve as directors of other communications services companies. As a result, these persons may be subject to conflicts of interest because of their investment or status as director that will have to be resolved by those persons and Alamosa. This conflict could require that such persons not participate in the decision-making related to, or implementation of, transactions or issues in which such conflicts arise. For a discussion of the magnitude of these risks, please see "Management -- Directors and Executive Officers" and "Certain Relationships and Related Transactions." WE HAVE A VERY LIMITED OPERATING HISTORY AND MAY NOT ACHIEVE OR SUSTAIN OPERATING PROFITABILITY OR POSITIVE CASH FLOWS, WHICH MAY LIKELY RESULT IN OUR INABILITY TO MAKE PAYMENTS ON THE NOTES Our operating history is very limited. We initiated commercial operations in our first market in June 1999. We expect to incur significant operating losses and to generate significant negative cash flow from operating activities at least through the year ending December 31, 2001. We have already incurred $18.2 million in operating losses through September 30, 1999. Our operating profitability will depend upon many factors, including, among others, our ability to market Sprint PCS services, achieve our projected market penetration and manage customer turnover rates. If we do not achieve and maintain operating profitability and positive cash flow from operating activities on a timely basis, we may be unable to make interest or principal payments on the notes and you could lose all or part of your investment. FAILURE TO OBTAIN ADDITIONAL CAPITAL, IF NEEDED TO COMPLETE THE BUILD-OUT OF OUR PORTION OF THE SPRINT PCS NETWORK, COULD CAUSE DELAY OR ABANDONMENT OF OUR DEVELOPMENT PLANS The build-out of our portion of the Sprint PCS network will require substantial capital. As of January 1, 2000, we estimated that requirements to complete the current build-out plan and fund working capital losses through the year 2001 were approximately $283 million. We plan to finance these requirements using the funds received from the initial public offering of our common stock and the remaining $178.1 million available under the Nortel financing as of December 31, 1999. Funds in addition to the proceeds from our initial public offering of common stock and the commitments under the Nortel financing could be required for a variety of reasons, including unforeseen delays, unanticipated expenses, increased capital requirements, higher than expected operating losses, engineering design changes and other technology risks or other corporate purposes. In addition, if we complete our build-out more rapidly than currently anticipated, or if we contract to develop additional markets, we will need to raise additional equity or debt capital. These additional funds may not be available. Even if those funds are available, we may not be able to obtain them on a timely basis, on terms acceptable to us or within limitations permitted under our existing debt covenants or the covenants with respect to the senior discount notes. Failure to obtain additional funds, should the need for them develop, could result in the delay or abandonment of our development and expansion plans. IF WE DO NOT MEET ALL OF THE CONDITIONS REQUIRED UNDER OUR NORTEL FINANCING AGREEMENTS, WE MAY NOT BE ABLE TO DRAW DOWN ALL OF THE FUNDS WE ANTICIPATE RECEIVING FROM NORTEL AND MAY NOT BE ABLE TO COMPLETE THE BUILD-OUT OF OUR PORTION OF THE SPRINT PCS NETWORK We have received $71.9 million as of December 31, 1999 under our financing agreements with Nortel. The remaining $178.1 million, which we expect to receive in the future, is subject at each funding date to several conditions, including: - acquiring minimum numbers of Sprint PCS subscribers; - providing coverage to a minimum number of residents; and - adhering to financial covenants. If we do not meet these conditions at each funding date, Nortel may choose not to lend any or all of the remaining amounts. If other sources of funds are not available, we may be unable to complete the build-out of our portion of the Sprint PCS network. If we do not have sufficient funds to complete our network build-out, we may be in breach of our management agreement with Sprint PCS and be in default under our financing from Nortel. IF WE DO NOT HAVE ACCESS TO THE CAPITAL MARKETS ON TERMS REASONABLY SATISFACTORY TO US, WE MAY BE UNABLE TO REPAY THE NORTEL FACILITY AT MATURITY Failure to repay the Nortel facility at maturity will result in a default under that agreement. It is unlikely that we can repay the Nortel facility without refinancing the facility, and we may have inadequate access to the capital markets to permit such refinancing. A default under the Nortel facility could: - prevent us from operating or completing the build-out of our portion of the Sprint PCS network; - constitute a default under the senior discount notes or a default under our affiliation agreements with Sprint PCS; and - make it extremely difficult for us to obtain any future financing. BECAUSE WE DEPEND HEAVILY ON OUTSOURCING, THE INABILITY OF THIRD PARTIES TO FULFILL THEIR CONTRACTUAL OBLIGATIONS TO US MAY DISRUPT OUR SERVICES OR THE BUILD-OUT OF OUR PORTION OF THE SPRINT PCS NETWORK Because we decided to outsource portions of our business, we depend heavily on third-party vendors, suppliers, consultants, contractors and local exchange carriers. We have retained those persons to: - design and engineer our systems; - construct base stations, switch facilities and towers; - lease base stations; - install T-1 lines; and - deploy our wireless personal communications services network systems. Specifically, our financing arrangements with Nortel make us especially dependent on them for network equipment, since we must use a specified amount of any funds borrowed from Nortel to purchase their equipment. In addition, we lease almost all of the tower sites for our wireless systems through a master lease agreement with Specialty Capital Services, Inc., now a subsidiary of American Tower Corporation. Specialty in turn has separate leasing arrangements with each of the owners of the sites. If Specialty or American Tower Corporation were to become insolvent or Specialty were to breach those arrangements, we may lose access to those base stations and experience extended service interruption in the areas serviced by those sites. The failure by any of our vendors, suppliers, consultants, contractors or local exchange carriers to fulfill their contractual obligations to us could materially delay construction and adversely affect the operations of our portion of the Sprint PCS network. OUR ROAMING ARRANGEMENTS MAY NOT BE COMPETITIVE WITH OTHER WIRELESS SERVICE PROVIDERS, WHICH MAY RESTRICT OUR ABILITY TO ATTRACT AND RETAIN CUSTOMERS We rely on roaming arrangements with other wireless service providers for coverage in some areas. Some risks related to these arrangements are as follows: - the quality of the service provided by another provider during a roaming call may not approximate the quality of the service provided by Sprint PCS; - the price of a roaming call may not be competitive with prices of other wireless companies for roaming calls; - customers may have to use a more expensive dual-band/dual mode handset with diminished standby and talk time capacities; - customers must end a call in progress and initiate a new call when leaving the Sprint PCS network and entering another wireless network; and - Sprint PCS customers may not be able to use Sprint PCS advanced features, such as voicemail notification, while roaming. If Sprint PCS customers are not able to roam instantaneously or efficiently onto other wireless networks, we may lose current Sprint PCS subscribers and our Sprint PCS services will be less attractive to new customers. IF WE RECEIVE LESS REVENUES OR INCUR MORE FEES THAN WE ANTICIPATE FOR SPRINT PCS ROAMING, WE MAY NOT BE ABLE TO OPERATE OUR BUSINESS PROFITABLY We are paid a fee from Sprint PCS or a Sprint PCS affiliate for every minute that a Sprint PCS subscriber based outside of our territory uses the Sprint PCS network in our territory. Similarly, we pay a fee to Sprint PCS for every minute that a Sprint PCS subscriber based in our territory uses the Sprint PCS network outside our territory. Sprint PCS customers from our territory may spend more time in other Sprint PCS coverage areas than we anticipate, and Sprint PCS customers from outside our territory may spend less time in our territory or may use our services less than we anticipate. As a result, we may receive less Sprint PCS roaming revenue than we anticipate or we may have to pay more Sprint PCS roaming fees than we collect. In addition, Sprint PCS could change the current fee for each Sprint PCS roaming minute used. If we were to receive less Sprint PCS roaming net revenue, we may not be able to operate our business profitably. For more information on roaming, see "Business -- Roaming." WE ARE LIKELY TO RECEIVE VERY LITTLE NON-SPRINT PCS ROAMING REVENUE SINCE THE SPRINT PCS NETWORK IS NOT COMPATIBLE WITH MANY OTHER NETWORKS A portion of our revenue may be derived from payments by other wireless service providers for use by their subscribers of the Sprint PCS network in our territory. However, the technology used in the Sprint PCS network is not compatible with the technology used by many other systems, which diminishes the ability of other wireless service providers' subscribers to use our services. Sprint PCS has entered into few agreements that enable customers of other wireless service providers to roam onto the Sprint PCS network. As a result, the actual non-Sprint PCS roaming revenue that we receive in the future is likely to be low relative to other wireless service providers. For more information on roaming, see "Business -- Roaming." For further information on the Sprint PCS network technology, see "Business -- Technology." OUR RAPID GROWTH MAY IMPAIR OUR ABILITY TO EXPAND OUR COVERAGE AND MANAGE OUR SYSTEMS Since our inception in July 1998, we have experienced rapid growth and development in a relatively short period of time. As we open more markets, we expect to continue to experience growth. The management of that growth will require, among other things: - continued development of our operational and administrative systems; - stringent control of costs of network build-out; - integration of our network infrastructure with the rest of the Sprint PCS network; - increased marketing activities; - the ability to attract and retain qualified management, technical and sales personnel; and - the training of new personnel. Failure to successfully manage our expected rapid growth and development could impair our ability to complete the build-out of our portion of the Sprint PCS network, manage the expanding systems in our territory and achieve profitability. OUR PROJECTED BUILD-OUT PLAN DOES NOT COVER ALL OF OUR TERRITORY, WHICH COULD MAKE IT DIFFICULT TO MAINTAIN A PROFITABLE CUSTOMER BASE Our projected build-out plan for our territory does not cover all areas of our territory. Upon completion of our current build-out plan, we expect to cover 65% of the resident population in our territory. As a result, our plan may not adequately serve the needs of the potential customers in our territory or attract enough subscribers to operate our business successfully. To correct this potential problem, we may have to cover a greater percentage of our territory than we anticipate, which we may not have the financial resources to complete or may be unable to do profitably. PARTS OF OUR TERRITORY HAVE LIMITED LICENSED SPECTRUM, AND THIS MAY AFFECT THE QUALITY OF OUR SERVICE OR RESTRICT OUR ABILITY TO PURCHASE SPECTRUM LICENSES FROM SPRINT PCS IN THOSE AREAS While Sprint PCS has licenses to use 30 MHz of spectrum throughout most of our territory, it has licenses covering only 10 MHz in New Mexico and Durango and 20 MHz in El Paso. In the future, as the number of subscribers in those areas increases, this limited licensed spectrum may not be able to accommodate increases in call volume and may lead to more dropped calls than in other parts of our territory. In addition, Sprint PCS has no obligation to sell us spectrum licenses in areas where Sprint PCS owns less than 20 MHz of spectrum. Accordingly, if Sprint PCS were to terminate our affiliation agreements with them, it is likely that we would be unable to operate our business in New Mexico and Durango. THE TECHNOLOGY WE USE MAY BECOME OBSOLETE OR LIMIT OUR ABILITY TO COMPETE EFFECTIVELY WITHIN THE WIRELESS INDUSTRY The wireless telecommunications industry is experiencing significant technological change. We employ code division multiple access digital technology, the digital wireless communications technology selected by Sprint PCS for its network. Code division multiple access technology may not provide the advantages expected by us or Sprint PCS. If another technology becomes the preferred industry standard, we would be at a competitive disadvantage and competitive pressures may require Sprint PCS to change its digital technology. We may be unable to respond to these pressures and implement new technology on a timely basis or at an acceptable cost. For more information on technology, including code division multiple access technology, see "Business -- Technology." OUR EXISTING STOCKHOLDERS, DIRECTORS AND OFFICERS MAY BE ABLE TO CONTROL THE OUTCOME OF SIGNIFICANT MATTERS PRESENTED TO STOCKHOLDERS FOLLOWING THE COMPLETION OF OUR INITIAL PUBLIC OFFERING OF COMMON STOCK Upon completion of our initial public offering of common stock, our existing stockholders, directors and officers, if they act as a group, will be able to control the outcome of matters submitted for stockholder action including the election of members to our board of directors and the approval of significant change in control transactions. This may have the effect of delaying or preventing a change in control. For more information on this subject, please refer to "Management" and "Principal Stockholders." ANTI-TAKEOVER PROVISIONS IN OUR CHARTER AND BYLAWS COULD DELAY A TAKEOVER OR CHANGE IN CONTROL OF ALAMOSA Our certificate of incorporation provides that our board of directors may issue preferred stock without stockholder approval. In addition, our bylaws provide for a classified board, with each board member serving a three-year term. These provisions, among others, may have the effect of discouraging a third party from making a tender offer or otherwise attempting to obtain control of Alamosa, even though a change in ownership might be economically beneficial to us. UNAUTHORIZED USE OF, OR INTERFERENCE WITH, THE SPRINT PCS NETWORK COULD DISRUPT OUR SERVICE AND INCREASE OUR COSTS We may incur costs associated with the unauthorized use of the Sprint PCS network including administrative and capital costs associated with detecting, monitoring and reducing the incidence of fraud. Fraudulent use of the Sprint PCS network may impact interconnection costs, capacity costs, administrative costs, fraud prevention costs and payments to other carriers for unbillable fraudulent roaming. In addition, our border markets are susceptible to uncertainties related to areas not governed by the Federal Communications Commission. For example, unauthorized microwave radio signals near the border in Mexico could disrupt our service in the United States. RISKS RELATING TO THE YEAR 2000 ISSUE MAY CAUSE INTERRUPTIONS IN SERVICE Our systems, the systems of Sprint or Sprint PCS and the systems of other third parties upon whom we depend may experience system interruptions resulting from the year 2000 date change. If difficulties do arise, our business may not be operational for a period of time. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Impact of Year 2000 Issue on the Operations and Financial Condition of Alamosa." INDUSTRY RISKS WE MAY EXPERIENCE A HIGH RATE OF CUSTOMER TURNOVER WHICH WOULD INCREASE OUR COSTS OF OPERATIONS AND REDUCE OUR REVENUE The wireless personal communications services industry in general and Sprint PCS in particular have experienced a higher rate of customer turnover as compared to cellular industry averages. In particular, our customer turnover may be high because: - Sprint PCS does not require its customers to sign long term contracts; and - Sprint PCS' handset return policy allows customers to return used handsets within 30 days of purchase and receive a full refund. A high rate of customer turnover could adversely affect our competitive position, results of operations and our costs of, or losses incurred in, obtaining new subscribers, especially because we subsidize some of the costs of initial purchases of handsets by customers. REGULATION BY GOVERNMENT AGENCIES AND TAXING AUTHORITIES MAY INCREASE OUR COSTS OF PROVIDING SERVICE OR REQUIRE US TO CHANGE OUR SERVICES Our operations and those of Sprint PCS may be subject to varying degrees of regulation by the Federal Communications Commission, the Federal Trade Commission, the Federal Aviation Administration, the Environmental Protection Agency, the Occupational Safety and Health Administration and state and local regulatory agencies and legislative bodies. Adverse decisions or regulations of these regulatory bodies could negatively impact Sprint PCS's operations and our costs of doing business. For example, changes in tax laws or the interpretation of existing tax laws by state and local authorities could subject us to increased income, sales, gross receipts or other tax costs or require us to alter the structure of our current relationship with Sprint PCS. CONCERNS OVER HEALTH RISKS POSED BY THE USE OF WIRELESS HANDSETS MAY REDUCE THE CONSUMER DEMAND FOR OUR SERVICES Media reports have suggested that radio frequency emissions from wireless handsets may: - be linked to various health problems resulting from continued or excessive use, including cancer; - interfere with various electronic medical devices, including hearing aids and pacemakers; and - cause explosions if used while fueling an automobile. Widespread concerns over radio frequency emissions may expose us to potential litigation or discourage the use of wireless handsets. Any resulting decrease in demand for our services could impair our ability to profitably operate our business. WORSE THAN EXPECTED FOURTH QUARTER RESULTS MAY SIGNIFICANTLY REDUCE OUR OVERALL RESULTS OF OPERATIONS The wireless industry is heavily dependent on fourth quarter results. Among other things, the industry relies on significantly higher customer additions and handset sales in the fourth quarter as compared to the other three fiscal quarters. Our overall results of operations could be significantly reduced if Alamosa has a worse than expected fourth quarter for any reason, including the following: - Alamosa's inability to match or beat pricing plans offered by competitors; - the failure to adequately promote Sprint PCS's products, services and pricing plans; - the inability of Alamosa to obtain an adequate supply or selection of handsets; - a downturn in the economy of some or all markets in our territory; or - a poor holiday shopping season. SIGNIFICANT COMPETITION IN THE WIRELESS COMMUNICATIONS SERVICES INDUSTRY MAY RESULT IN OUR COMPETITORS OFFERING NEW SERVICES OR LOWER PRICES THAT WOULD PREVENT US FROM OPERATING PROFITABLY Competition in the wireless communications services industry is intense. We anticipate that competition will cause the market prices for two-way wireless products and services to decline in the future. Our ability to compete will depend, in part, on our ability to anticipate and respond to various competitive factors affecting the telecommunications industry. Our dependence on Sprint PCS to develop competitive products and services and the requirement that we obtain Sprint PCS's consent to sell non-Sprint PCS approved equipment may limit our ability to keep pace with our competitors on the introduction of new products, services and equipment. Some of our competitors are larger than us, with greater resources and more extensive coverage areas, and may market other services, such as landline telephone service, cable television and Internet access, with their wireless communications services. In addition, we may be at a competitive disadvantage since we may be more highly leveraged than some of our competitors. Furthermore, there has been a recent trend in the wireless communications industry towards consolidation of wireless service providers through joint ventures, mergers and acquisitions. We expect this consolidation to lead to larger competitors over time. We may be unable to compete successfully with larger competitors who have substantially greater resources or who offer more services than we do. For more information on the competition we face in the wireless communications industry, see "Business -- Competition."

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+RISK FACTORS ANY INVESTMENT IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. YOU SHOULD CONSIDER CAREFULLY THE FOLLOWING INFORMATION ABOUT THESE RISKS, TOGETHER WITH THE OTHER INFORMATION CONTAINED IN THIS PROSPECTUS, BEFORE YOU DECIDE TO BUY OUR COMMON STOCK. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCUR, OUR BUSINESS WOULD LIKELY SUFFER. IN ANY SUCH CASE, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE, AND YOU MAY LOSE ALL OR PART OF THE MONEY YOU PAID TO BUY OUR COMMON STOCK. Risks Related to Our Business It is difficult to evaluate our business and prospects because we have a limited operating history. We launched our Web site in December 1995 and were incorporated in July 1996. Accordingly, we have a relatively short operating history from which to evaluate our business and our prospects. Investors should consider our prospects in light of the risks, expenses and difficulties frequently encountered by early-stage companies, particularly companies in the intensely competitive Internet industry. These risks include our ability to: - develop and manage our business model; - attract a larger number of members to our Web site; - increase awareness of our brand; - offer compelling content; - maintain our current, and develop new, strategic relationships; - attract a large number of sponsors and merchants from a variety of industries; - attract, retain and motivate qualified personnel; - respond effectively to competition; - generate sufficient revenue and control costs to achieve and maintain profitability; - improve our operational and financial systems; and - manage our growth. We may not be able to adequately address any of these risks. We have a history of losses, and we anticipate losses in the foreseeable future. We have not generated enough revenue to cover the substantial amounts we have spent to create, launch and enhance our products and services. We have incurred net losses since the formation of our business in 1996. At December 31, 1999, we had an accumulated deficit of $35.0 million. We expect to continue to incur significant operating losses and negative cash flows for the foreseeable future. We may never achieve profitability. Even if we do achieve profitability, we may not be able to sustain it on a quarterly or annual basis in the future. Successfully executing our business plan depends on, among other things, our ability to significantly increase our revenue and meet the following challenges, to: - increase awareness of our brands; - increase membership and member usage of our Web site; - provide our users with superior communications, educational, commerce and community features; and - enhance our systems and technology to support increased traffic to our Web site. Accordingly, we expect to incur significant expenses in order to: - maintain and form new business alliances with sponsors and strategic partners; - acquire entities that provide us with complementary product or content offerings or technologies; - expand our technology infrastructure to effectively manage our growth; and - increase our marketing and promotional activities. We may not generate sufficient revenue to offset these expenditures. If our revenue does not grow as we anticipate or if our operating expenses exceed our expectations or cannot be adjusted quickly to match revenue, we will continue to experience significant losses on a quarterly or annual basis. If we do not provide attractive goods and services, our Web site will not generate interest from our members, sponsors and merchants, and our business model will suffer. Our business model relies on using our platform and membership base to generate revenue from different sources. To be profitable, we will need to provide goods and services that are attractive to our members, sponsors and merchants. We rely mostly on our users to generate content that is attractive and pertinent to develop and maintain our Web site. A decline in engaging member-generated and third party content could make our Web site less attractive. We cannot guarantee that Internet users will continue to be interested in our Web site. A decline in membership or usage of our Web site would decrease our revenue. If we are unable to generate sufficient advertising-related and online commerce revenue, our total revenue will be significantly reduced. We currently derive substantially all of our revenue from the sale of sponsorships, advertisements and other promotional services. We also expect to derive a growing portion of our revenue in the future from the generation of online commerce. If we fail to sell advertising or generate online commerce revenue, our total revenue will be significantly reduced. Advertising and online commerce revenue are directly related to Web site traffic. Market acceptance of Internet-based advertising is uncertain and depends largely on advertisers' determinations that the Internet is an effective medium for advertising. Our ability to generate significant advertising and online commerce revenue depends upon several other factors, including: - the continued development of strong brand recognition and engaging content to attract and retain a large, demographically-attractive base of members and significant Web site traffic; - our ability to continue to develop and update effective advertising delivery and measurement systems; - our ability to maintain and increase the number of our advertisers given the growing number of outlets for advertisers on the Internet; and - the volume of online commerce sales and our ability to charge commissions for online commerce sales generated by our Web site. Our operating results depend on our ability to maintain and form new business alliances. Our ability to develop and maintain strategic alliances and relationships is an important factor in maintaining our membership base. Our failure to acquire or maintain sponsors, strategic partners and other key relationships could result in a decrease in revenue and the number of members or an increase in expenses. Additionally, committing significant managerial, technical and financial resources to developing business alliances may divert our resources and our management's time and attention from our other business efforts. If we are not successful in integrating acquisitions, we will not be able to execute on our business strategy. Since June 30, 1999, we have acquired four businesses. Our management has had limited experience in assimilating acquired organizations and products into our operations. We may not successfully integrate the operations, personnel or products that we have acquired in the past or may acquire in the future. Our growth strategy includes acquiring or making investments in complementary businesses, products, services or technologies. As a result, we may from time to time evaluate acquisition opportunities that could provide us with additional product or content offerings or additional industry expertise. We may not be successful in completing an acquisition or in making the acquisition on commercially viable terms. Any future acquisition could result in difficulties assimilating acquired operations and products, diversion of our attention away from other business issues and amortization of acquired intangible assets which could negatively impact our earnings. Specifically, we expect that future transactions may involve the acquisition of early-stage technology companies. Acquiring these companies may result in problems related to the integration of technology and inexperienced management teams. Furthermore, we may incur debt or issue equity securities to pay for future acquisitions. Issuing convertible debt or equity securities would dilute the ownership of our existing stockholders. Growth in our operations has and will continue to strain our resources and our failure to effectively manage growth could harm our business. We have recently experienced significant growth and are planning to further expand our business. As of February 29, 2000, we had 255 employees, compared to 57 employees as of June 30, 1999. We also manage a team of over 1,200 independent contractors on college campuses nationwide. This growth has placed a significant strain on our management, operational and financial resources. We are currently in the process of upgrading our systems software. If we are not successful in implementing these new systems, our growth could be curtailed and we may not be able to take advantage of all market opportunities. In addition, to support the expected growth, management will have to identify, hire, train and manage required personnel. Furthermore, our success also depends to a significant extent on the ability of our management to operate effectively, both individually and as a group. A number of the members of our senior management team joined us recently. Our management team has had a limited time to work together and as a result, may have difficulty working together to successfully manage our business. If we are unable to expand our online capacity, computer systems and related features to support increased volume on our Web site in a timely manner, our business may suffer. A key element of our strategy is to generate a high volume of traffic on our Web site. However, growth in the number of users accessing our site may strain or exceed the capacity of our computer systems and lead to declines in performance or systems failure. We believe that we will need to continually improve and enhance the functionality and performance of our content and advertisement distribution, online commerce and other technical systems to accommodate growth in user demand. As a result, we intend to continually upgrade our existing systems and implement new systems to keep pace with rapidly changing technologies and evolving industry standards. Our inability to add additional hardware and software to upgrade our existing technology or network infrastructure to accommodate increased traffic would cause decreased levels of customer service and satisfaction. We are in the process of transitioning the hosting of our Web site from Simple Network Communications in San Diego, California to another provider. We are also in the process of migrating our SQL Server database to an Oracle 8i infrastructure. We may experience interruptions in our systems or our Web site during these transitions. Any interruption or disruption of our systems could have a material adverse effect on our business and financial condition. We depend on third parties for software, systems and related services. For example, we rely on Simple Network Communications for our Web site hosting. Several of the third parties that provide software, systems or services to us have limited operating histories and are themselves dependent on reliable delivery of services from others. If the software, systems or related services we currently obtain from third parties do not function properly or are not updated, we would need to purchase these items from other third party providers. This would require an unplanned increase in operating expenses and could cause a disruption in our business. If we are unable to retain key personnel or attract new personnel we will not be successful. Our success will depend to a significant extent on the continued service of our senior executives and other key employees, including sales and marketing personnel, many of whom would be difficult to replace. Our future success and ability to grow our business also depends in large part on our ability to attract and retain additional experienced sales, marketing and technical personnel. If we lost the services of one or more of our executives or key employees or failed to hire the necessary additional people, our ability to implement our business strategy would be adversely affected and our business would suffer. Competition for qualified people in the Internet industry is intense. We expect this competition to remain intense, and we may not succeed in attracting or retaining such people. In addition, new employees generally require substantial training. This training will require significant resources and management attention. Competition for users and advertisers could adversely affect our position in the market and our financial results. The market for online users and advertisers on the Internet is rapidly evolving. Competition for members, visitors, sponsors and merchants is intense and is expected to increase over time. Barriers to entry are relatively low. We compete for visitors, traffic, sponsors and online merchants with Web directories, search engines, content sites, online service providers and traditional media companies. We also face competition from other companies maintaining Web sites dedicated to college students as well as high-traffic Web sites sponsored by companies such as CBS, Disney, Excite, Lycos, MTV, Time Warner and Yahoo! We also compete with other companies targeting the student population, such as: - publishers and distributors of traditional offline media, particularly those targeting college students, such as campus newspapers, other print media, television and radio; and - vendors of college student information, merchandise, products and services distributed through online and offline means, including retail stores, mail and schools. Increased competition from these and other sources could require us to respond to competitive pressures by establishing pricing, marketing and other programs or seeking out additional strategic alliances or acquisitions that may be less favorable to us than we could otherwise establish or obtain. Many of our competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical and marketing resources than we do. In addition, substantially all of our current advertising customers have established collaborative relationships with other high-traffic Web sites. Our advertising customers might conclude that other Internet businesses, such as search engines, commercial online services and sites that offer professional editorial content are more effective sites for advertising than we are. Moreover, we may be unable to maintain either the level of traffic on our Web site or a stable membership base, which would make our site less attractive than those of our competitors. We currently derive substantially all of our revenue from sponsorships, advertising and other promotional services, and our business model depends in part on increasing the amount of such revenue. The market for this type of revenue is highly competitive. We must maintain and increase our traffic to attract sponsors and advertisers and compete successfully for advertising revenue. We believe that the primary competitive factors in attracting and retaining users are: - quality and pertinence of content and services; - brand recognition as well as consumer awareness of our content and services; - user affinity and loyalty; - demographic focus; - variety of value-added services; and - critical mass of users. We believe that the principal competitive factors in attracting and retaining sponsors and advertisers are: - the amount of traffic on a Web site; - brand recognition; - the demographics of a site's users; - the ability to offer targeted audiences; - the average duration of user visits; and - cost-effectiveness. Our competitors may develop content and service offerings that are superior to ours or that achieve greater market acceptance than our services. If our content and service offerings fail to achieve success in the short term, we could suffer an insurmountable loss in market share and brand acceptance. Our business is subject to seasonal fluctuations that will affect our revenue and operating results and could cause the price of our common stock to decline. Our operating results are dependent upon the college student market and they vary seasonally based upon the typical school year. If we are unable to effectively manage our resources in anticipation of the seasonality of our revenue and the increased costs we expect to incur during periods of lower revenue, our business, operating results and financial condition will be materially adversely affected. We tend to experience increased Web site traffic and membership enrollment in the beginning of the fall and winter academic terms, which places a strain on our systems during these periods. Our limited operating history and rapid growth make it difficult for us to fully assess the impact of seasonal factors on our business. However, because our business is dependent upon the student market, we expect that our revenue will be subject to seasonal fluctuations. We expect our revenue to be higher during our first and fourth quarters due to the increased activity associated with the school term. Conversely, the second and third quarters may have relatively less revenue since they include months when schools are not typically in session. In addition, we may undertake activities designed to improve our Web site or other services during periods when school is not in session to prepare for the next school year, increasing our costs during periods of decreased revenue. In addition to the seasonality which we experience due to our emphasis on the college market, seasonality in Internet usage and advertising expenditures is also likely to cause fluctuations in operating results from quarter to quarter. Usage on the Internet has typically declined during the summer and year-end vacation and holiday periods. Advertising sales in traditional media, such as broadcast and cable television, generally decline in the first and third quarters of each year. Depending on the extent to which Internet and commercial online services are accepted as an advertising medium, seasonality in the level of advertising expenditures would become more pronounced for Internet-based advertising. Due to the factors discussed above, our revenue and operating results are difficult to forecast. We believe that our quarterly revenue, expenses and operating results will vary significantly in the future and that period-to-period comparisons are not necessarily meaningful and are not indicative of future performance. As a result, it is likely that in some future quarter or years our results of operations will fall below the expectations of securities analysts or investors, which would cause the trading price of our common stock to decline. The ability of colleges and universities to prevent our student representatives from conducting promotional activities on campus could impede our membership growth. We currently derive a significant percentage of our membership through promotional activities conducted primarily on universities and college campuses by our student campus representatives. At present, we employ over 1,200 student representatives on over 1,000 college and university campuses nationwide. These student representatives conduct promotional activities on these campuses to recruit new members by, among other things, sponsoring various events and posting digital photos of students and campus events on our online photo gallery. Our ability to recruit new members may be impaired if colleges and universities restrict our ability to market on campus. Some colleges and universities have tried to prevent us from conducting promotional activities on campus by sending us cease-and-desist letters and telling our campus representatives to stop their activities. In addition, colleges and universities may enter into exclusive contracts with other online companies that might prohibit us from promoting our Web site on campus. If colleges and universities increasingly prevent our student representatives from conducting promotional activities on campus, the growth in our student membership could suffer. Our success depends on the protection of our intellectual property rights which may be difficult and costly. Our success depends on the protection of our databases and proprietary Web site-related software as well as the goodwill associated with our service marks and other proprietary intellectual property rights. A substantial amount of uncertainty exists concerning the application of copyright and trademark laws to the Internet and other digital media. Existing laws may not adequately protect our content, our software code or our Internet addresses, commonly referred to as domain names. We have filed applications to register a number of our service marks, but we may not be able to secure registration for these service marks. We have not applied for the registration of all of our service marks. Effective trademark, service mark, copyright and trade secret protection may not be available in every country in which our content, products and services are offered. If we are prevented from using our service marks, we would need to obtain different universal resource locators. We would also need to rebuild our brand identity with our customers and users. Our operating expenses would substantially increase if we had to rebuild our brand identity or reimplement our Web sites. We also have invested resources in acquiring domain names for current and potential future use. We may not be entitled to use such names under applicable trademark and similar laws, and other desired domain names may not be available. Despite our efforts to protect our proprietary rights, the steps we have taken may not be adequate. Third parties may infringe or misappropriate our copyrights, trademarks or other intellectual property. In addition, others could independently develop substantially equivalent intellectual property. Enforcing our intellectual property rights could entail significant expense and could prove difficult or impossible. In addition, third parties may bring claims of copyright, trademark or service mark infringement, patent violation, misappropriation of creative ideas or formats or other infringement claims against us with respect to our content, including the design and functionality of our Web site or any third-party content carried by us. Any such claims, with or without merit, could prove time-consuming to defend, result in costly litigation, divert management attention, require us to enter into costly royalty or licensing arrangements or prevent us from using important technologies or offering products and services. Our content and technology offerings could infringe the intellectual property rights of others, and claims against us could be costly and require us to enter into licensing or royalty arrangements and discontinue the use of that content or technology. We currently offer online lecture notes for college courses and hire students to produce and post these notes to our Web site. We may be subject to claims that our online lecture notes infringe on the intellectual property rights of professors and universities. In most cases, we have not obtained a license or other authorization to post these lecture notes. From time to time, we have received requests from professors and universities that we remove the lecture notes from our Web site. Professors and universities may assert trademark, copyright, and other types of infringement, unfair competition or trespass claims against us or our student representatives. If we are forced to defend against any such claims or any other claims of infringement of third party intellectual property rights, whether they are with or without merit or are determined in our favor, we may face costly litigation, loss of access to, and use of, some of our content, diversion of managerial resources, or disruption of our operations. As a result of such a dispute, we may be required to develop non-infringing content, enter into royalty or licensing agreements, discontinue use and remove this content from our Web sites, or be forced to pay potentially significant damages for past conduct with respect to this content. Royalty or licensing agreements, if required, may be unavailable on terms acceptable to us, or at all. If there is a successful claim of infringement against us and we are unable to develop non-infringing content or license the infringed or similar content on a timely basis, our business could be materially harmed. Colleges may attempt to restrict access to our Web site We believe a significant portion of our users access our Web site through their local university computer networks. Recently, some universities have begun to restrict access to certain Web sites due to the strains placed on the universities' systems resulting from the high volume of data being uploaded and downloaded to and from these Web sites. Colleges may also attempt to limit access to our Web site due to its content. Given the interactive nature of our Web site, universities may in the future limit access to our site through their networks. If a substantial number of universities restrict access to our Web site, the traffic on our Web site will decrease and our business and financial condition could be materially and adversely harmed. Third-party technology necessary for the successful operation of our business may not be available on commercially reasonable terms or at all. Some of the technology incorporated in our Web site is based on technology licensed from third parties. As we continue to introduce new services, we may need to license additional technology from third parties. If we are unable to timely license needed technology on commercially reasonable terms, we could experience delays and reductions in the quality of our services. If someone makes a claim against us relating to proprietary technology or information, we may seek to license such intellectual property. We may not be able to obtain licenses on commercially reasonable terms, or at all. Our prospects for obtaining additional financing, if required, are uncertain and failure to obtain needed financing could affect our ability to pursue future growth. Although we believe that, following this offering, our cash reserves and cash flows from operations will be adequate to fund our operations at least through the next 12 months, we do not have a long enough operating history to know with certainty whether our existing cash and the proceeds of this offering will be sufficient to finance our anticipated growth. Accordingly, these funds may not be adequate and additional funds may be required either during or after that period. We may need to raise additional funds if our estimates of revenue, working capital or capital expenditure requirements change or prove inaccurate, if we are required to respond to unforeseen technological or marketing hurdles or if we choose to take advantage of unanticipated opportunities. Further, additional financing may not be available when required. If additional funds are raised through the issuance of equity securities, the percentage ownership of our then existing stockholders will be reduced. Any new securities issued may have rights, preferences or privileges senior to those securities held by you. If we raise additional funds through the issuance of debt, we may become subject to restrictive covenants. If adequate funds are not available to satisfy either short- or long-term capital requirements, we may be required to limit our operations significantly. Our future capital requirements are dependent upon many factors, including: - the rate at which we expand our sales and marketing operations; - the extent to which we expand our content and service offerings; - the extent to which we develop and upgrade our technology and data network infrastructure; and - the response of competitors to our content and service offerings. We believe that we have a contingent liability of approximately $3.3 million plus interest due to our issuances of securities, which may have been in violation of securities laws. We have issued shares or options to purchase shares of our common stock to some of our existing stockholders, our employees, consultants, directors and on-campus representatives. At the time these options were issued, we believed that each of the issuances were exempt from the registration requirements of the Securities Act. However, due to the total number of shares and options issued, the issuance of these shares and options may not have qualified for any exemption from qualification under California and other state securities laws. In addition, we have assumed options issued by Versity.com and converted them into options to purchase shares of our common stock. Our assumption of these options also may not qualify for any exemption from qualification under California and other state securities laws. We may be required, or we may elect, at some time in the future, to make a rescission offer, in which we would offer to repurchase from these persons all shares issued pursuant to option exercises by these persons at the purchase or exercise price paid for these shares, plus interest at the rate of 10% per year from the date of issuance until the rescission offer expires. To comply with California and other state securities laws, we may also offer, or be required to offer, to repurchase all unexercised options issued to such persons at 20% of the option exercise price multiplied by the number of shares subject to such options, plus interest at the rate of 10% per year from the date of issuance until the rescission offer expires. We believe we could be required to pay up to approximately $3.3 million plus the total amount of interest on that amount as described above based on the number of securities that may have been improperly issued. As of the date of this prospectus, we are not aware of any claims for rescission against us with respect to the foregoing securities issuances. If we are required to repurchase all of the securities which may have been issued in violation of securities laws, our operating results and liquidity during the period in which such repurchase occurs could be materially adversely affected. Risks Related To Our Industry If sponsors and merchants do not continue or increase their usage of the Internet as an advertising medium, our revenue may decline or we may not grow. We expect to derive a substantial portion of our revenue from sponsorships and advertising for the foreseeable future. The prospects for continued demand and market acceptance for Internet marketing solutions are uncertain. If the Internet does not develop as an effective and measurable medium for advertising, or if it develops more slowly than expected, our business will suffer. Most advertising agencies and potential advertisers, particularly local advertisers, have only limited experience advertising on the Internet and may not devote a significant portion of their advertising expenditures to Internet advertising. Moreover, advertisers that have traditionally relied on other advertising media may not advertise on the Internet. In addition, advertising on the Internet is at a much earlier stage of development in international markets as compared to the United States and may not fully develop in these markets. As the Internet evolves, advertisers may find Internet advertising to be a less attractive or effective means of promoting their products and services relative to traditional methods of advertising and may not continue to allocate funds for Internet advertising. This growth may not occur or may occur more slowly than estimated. In addition, if a large number of Internet users use filter software programs that limit or remove advertising from the user's monitor, advertisers may choose not to advertise on the Internet. Moreover, there are no widely accepted standards for measuring the effectiveness of Internet advertising, and standards may not develop sufficiently to support Internet advertising as a significant advertising medium. Intense competition in the sale of advertising on the Internet has led different vendors to quote a wide range of rates and offer a variety of pricing models for various advertising services. As a result, we have difficulty projecting future advertising revenue and predicting which pricing models advertisers will adopt. This difficulty could cause us to adopt a pricing model which later proves not to be commercially viable. Our success depends on continued growth in the use of the Internet and the ability of the Internet infrastructure to support such growth. Our industry is new and rapidly evolving. A decrease in the growth of Web usage, particularly usage by college students, would harm our business. The following factors may inhibit growth in Web usage: - inadequate Internet infrastructure; - security and privacy concerns; - inconsistent quality of content and service; and - lack of cost-effective, high-speed service. Our success depends in large part on the maintenance of the Internet infrastructure, such as a reliable network that provides adequate speed, data capacity and security, and timely development of products that enable reliable Internet access and services, such as high-speed modems. To the extent that the Internet continues to experience significant growth in the number of users, frequency of use and amount of data transmitted, there can be no assurance that the Internet infrastructure will continue to be able to support the demands placed on it or that the performance or reliability of the Internet will not be adversely affected. Web sites have experienced interruptions in their service as a result of outages and other delays occurring throughout the Internet network infrastructure. If these outages or delays occur frequently in the future, Internet usage, as well as the usage of our Web sites, could grow more slowly than expected or could decline. In addition, the Internet could lose its commercial viability as a form of media due to delays in the development or adoption of new standards and protocols to accommodate increased levels of Internet activity. There can be no assurance that the infrastructure or complementary products and services necessary to establish and maintain the Internet as a viable commercial medium will be developed on a timely basis or at all, or, if they are developed, that the Internet will become a viable commercial medium for us or for our affiliates and advertisers. If the necessary infrastructure or complementary services or facilities are not developed, or if the Internet does not become a viable commercial medium or platform for advertising, promotions and e-commerce, our business, our financial condition and the results of our operations would suffer. Our networks may be vulnerable to unauthorized access, computer viruses and other disruptive problems. A party who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. Internet and online service providers have in the past experienced, and may in the future experience, interruptions in service as a result of the accidental or intentional actions of Internet users, current and former employees or others. Moreover, any well-publicized compromise of security could deter people from using the Internet or from using it to conduct transactions that involve transmitting confidential information. We may be required to expend significant capital or other resources to protect against the threat of security breaches or to alleviate problems caused by such breaches. Although we intend to continue to implement industry-standard security measures, there can be no assurance that the measures we implement will not be circumvented in the future. Eliminating computer viruses and alleviating other security problems may require interruptions, delays or cessation of service to users accessing Web pages that deliver our content and services, any of which could harm our business, our financial condition and the results of our operations. Our storage or use of personal information about our users may expose us to significant liability. If third parties are able to penetrate our network security or otherwise misappropriate our users' personal information, we could be subject to liability. We could be held responsible for third party impersonations of our members or other similar fraud claims. We could also be held responsible for disclosing personal information or images, such as our disclosing such information for unauthorized marketing purposes or for including it in our photo gallery and Web cam section. These claims could result in litigation. Although we carry general liability insurance, this insurance may not be available to cover a particular claim or may be insufficient. Additionally, our user community exists in part because of our members' willingness to provide information about themselves. If claims, litigation, regulation or the acts of third parties reduce our members' willingness to share this information or our ability to use it, the attractiveness of our Web site will decline, which would reduce our ability to generate revenue. In addition, the Federal Trade Commission and state agencies have been investigating various Internet companies regarding their use of personal information. In 1998, the United States Congress enacted the Children's Online Privacy Protection Act of 1998. The regulations promulgated under this act have made it necessary for us to restrict membership on our sites to individuals who are age 13 or older. In addition, the FTC, the federal government and various states have indicated that each may enact additional regulations regarding the use of personal information unless companies put into place and enforce their own privacy policies. We could incur additional expenses if new regulations regarding the use of personal information are introduced or if our privacy practices are investigated. Furthermore, the European Union recently adopted a directive addressing data privacy that may limit the collection and use of information regarding Internet users. This directive and regulations enacted by other countries may limit our ability to target advertising or collect and use information internationally. We may be held liable for our services and user-generated content. We host a wide variety of communication, education, commerce and community features that enable our users to exchange information, conduct business and engage in various online activities. Claims could be made against us for obscenity, negligence, defamation, libel, copyright, service mark or trademark infringement, personal injury or on other legal grounds based on the nature and content of information that may be posted online by our users. The law is currently unsettled as to the liability of providers of these online services for the activities of their users. In addition, we could be exposed to liability with respect to the selection of listings that may be accessible through our CollegeClub.com-branded products and properties, or through content and materials that may be posted by users on message boards or in clubs, chat rooms or other interactive community-building services. If any information provided through our services contains errors, third parties could make claims against us for losses incurred in reliance on such information. Our e-mail and other communication services expose us to potential risks, such as liabilities or claims resulting from unsolicited e-mail, voicemail, lost or misdirected messages, illegal or fraudulent use of e-mail or telephone lines, or interruptions or delays in communications service. The imposition of potential liability for our content or services could require us to implement measures to reduce our exposure to such liability, which may require us to expend substantial resources or to discontinue some content or service offerings. While we carry general liability insurance, it may not be adequate to compensate us in the event we become liable for our content or services. We may lose members and our reputation may suffer because of unsolicited bulk e-mail, or spam. Unsolicited bulk e-mail, or spam, and our attempts and others' attempts to control spam could harm our business and our reputation. To the extent our spam-blocking efforts are not effective, our systems may become unavailable or may suffer from reduced performance. Spam-blocking efforts by others may also result in others blocking our members' legitimate messages. Additionally, our reputation may be harmed if e-mail addresses with our domain names are used in this manner. Any of these events may cause members to become dissatisfied and discontinue their use of our Web site. Our systems may fail or be interrupted, limiting our user traffic and harming our business. We maintain substantially all of our computer and communications hardware at the facilities of Simple Network Communications in San Diego, California but we are in the process of transitioning the hosting of our Web site to another provider. We may experience interruptions in our systems or our Web site during this transition. Any disruption or interruption of our systems could have a material adverse effect on our business and financial condition. Our systems and operations could be damaged or interrupted by fire, flood, power loss, telecommunications failure, break-ins, earthquake and similar events at that location. Computer viruses, physical or electronic break-ins and similar disruptions could also cause system interruptions, delays and loss of critical data and could prevent us from providing services. The ability of college students to access our Web site directly affects our revenue. In the past we have experienced infrequent system interruptions that made our Web site unavailable. Similar system interruptions may reduce the traffic to our Web site. We expect that these interruptions will continue in the future from time to time. We may need to add additional software and hardware from time to time and otherwise upgrade our systems and network infrastructure to accommodate increased traffic on our Web site and to promote the stability of our network. We are currently in the process of upgrading our systems software and functionality in order to increase the capacity and scalability of our Web site to accommodate increased user traffic. We cannot accurately project the rate or timing of any increases in traffic on our site and, therefore the integration and timing of future upgrades are uncertain. In addition, we cannot guarantee that our current system or functionality upgrades will be completed on a timely basis or that they will not result in system interruptions. Our Web site services depend on complex software developed by third parties and us. Software often contains defects, particularly when first introduced or when new versions are released, that cannot be detected until the software is deployed. These defects could: - cause service interruptions that damage our reputation; - increase our service costs; - cause us to lose revenue; - discourage advertisers from placing advertisements on our Web site; or - divert our development resources. Our reliance on third-party telecommunications service providers also exposes us to the risks that those providers will fail to provide service or that their service quality will not be acceptable. In either event, we would likely lose users who are dissatisfied with our service or face reduced traffic. Since we do not have direct control over our telecommunications carriers' network reliability and the quality of their service, we may not be able to provide consistently reliable access for our users. If we are unable to respond to rapid technology change in the Internet market, we will not remain competitive and may lose users. To remain competitive, we must continue to enhance and improve the responsiveness, functionality and features of our Web site. If we are unable, for technical, legal, financial or other reasons, to adapt in a timely manner in response to changing technology in the Internet market, we will not remain competitive. The Internet is characterized by rapid technological change that could render our existing Web site and proprietary technology and systems obsolete. Our success will depend, in part, on our ability to: - license leading technologies useful in our business; - enhance our existing services; - develop new services and technology that address the increasingly sophisticated and varied needs of college students; and - respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis. We may experience difficulties that delay or prevent us from being able to do any of the above. Material delays in introducing new technologies and enhancements to our services may cause customers and advertisers to make purchases from or visit the Web sites of our competitors. We could also incur substantial costs if we need to modify our services or infrastructure to adapt to these changes. Existing and future regulation of the Internet may slow its growth, resulting in decreased demand for our services and increased costs of doing business. We expect more stringent laws and regulations to be enacted due to the increasing popularity and use of the Internet and other online services. New and existing laws and regulations are likely to address a variety of issues, including: - user privacy and expression; - taxation and pricing; - the rights and safety of children; - intellectual property; - information security; - anticompetitive practices; - the convergence of traditional channels with Internet commerce; - property ownership; - negligence; - defamation; - obscenity and indecency; - distribution; - the characteristics and quality of products and services; - online content; - data collection; - access charges; - liability for third party activities; and - jurisdiction. Regulation could limit growth in the use of the Internet generally and decrease the acceptance of the Internet as a communications and commercial medium. Other federal, state, local or foreign laws, regulations and policies, either now existing or that may be adopted in the future, may apply to our business and may subject us to significant liability, significantly limit growth in Internet usage, prevent us from offering particular Internet services or otherwise harm our business, our financial condition and the results of our operations. Although our online transmissions generally originate in California, the governments of other states or foreign countries might attempt to regulate our transmissions or levy sales or other taxes relating to our activities. We may be subject to Sections 5 and 12 of the Federal Trade Commission Act, or the FTC Act, which regulate advertising in all media, including the Internet, and require advertisers to have substantiation for advertising claims before disseminating advertisements. The FTC Act prohibits the dissemination of false, deceptive, misleading and unfair advertising, and grants the Federal Trade Commission, or the FTC, enforcement powers to impose and seek civil and criminal penalties, consumer redress, injunctive relief and other remedies upon persons who disseminate prohibited advertisements. We could be subject to liability under the FTC Act if we were found to have participated in creating and/or disseminating a prohibited advertisement with knowledge, or had reason to know that the advertising was false or deceptive. The FTC recently brought several actions charging deceptive advertising via the Internet, and is actively seeking new cases involving advertising via the Internet. We may also be subject to the provisions of the recently enacted Communications Decency Act, or the CDA, which, among other things, imposes substantial monetary fines and/or criminal penalties on anyone who distributes or displays prohibited material over the Internet or knowingly permits a telecommunications device under its control to be used for such purpose. Although the manner in which the CDA will be interpreted and enforced and its effect on our operations cannot yet be fully determined, the CDA could subject us to substantial liability. The CDA could also limit the growth of the Internet generally and decrease the acceptance of the Internet as an advertising medium. Increased use of the Internet has burdened the existing telecommunications infrastructure and has led to interruptions in phone service in areas with high Internet use. Several telecommunications companies and local telephone carriers have petitioned the Federal Communications Commission to regulate online service providers in a manner similar to long distance telephone carriers and to impose access fees. If this were to occur, the cost of communicating on the Internet could increase substantially, potentially decreasing the use of the Internet. The applicability of existing laws in various jurisdictions governing issues such as property ownership, sales and other taxes, libel and personal privacy to the Internet and other online services is uncertain and may take years to resolve. Any new legislation or regulation, the application of laws and regulations from jurisdictions whose laws do not currently apply to our business, or the application of existing laws and regulations to the Internet and other online services could increase our costs of doing business, discourage Internet communications and reduce demand for our services. We may be subject to liability for products sold through our Web site. Consumers may sue us if any of the products sold through our Web site are defective, fail to perform properly or injure the user. Although we intend to include provisions in our agreements with manufacturers and companies to limit our exposure to liability claims, these limitations may not prevent all potential claims. Liability claims resulting from our sale of products could require us to spend significant time and money in litigation or to pay significant damages. Risks Related To This Offering The number of shares eligible for public sale after this offering could cause our stock price to decline. If our existing stockholders sell their shares of our common stock in the public market following the offering, the market price of our common stock could decline. Moreover, the perception in the public market that our existing stockholders might sell shares of common stock could depress the market price of the common stock. These sales, and the possibility of these sales, could make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. Please see "Shares Eligible for Future Sale" for further details regarding the number of shares eligible for public sale after this offering. The liquidity of our stock is uncertain because it has never been publicly traded, and it could be difficult to sell your shares. Prior to this offering, there has been no public market for our common stock. We cannot predict if an active trading market in our common stock will develop or how liquid that market might become. The market price of the common stock may decline below the initial public offering price. The initial public offering price for the shares will be determined by negotiations between us and the representatives of the underwriters and may not be indicative of prices that will prevail in the trading market. Please see "Underwriting" for more information regarding how the initial public offering price was determined. We may apply the proceeds of this offering to uses that do not increase our operating results or market value. We presently intend to use a portion of the net proceeds from this offering to promote our brand, expand sales and marketing and engage in strategic business alliances and acquisitions. The balance of the net proceeds of this offering will be used for working capital and general corporate purposes, including Web site expansion as more fully described in "Use of Proceeds." General corporate purposes also include expenditures made in the day-to-day operation of our business. Our use of proceeds is subject to change at our management's discretion. The amounts actually expended for each of the purposes listed above may vary significantly depending upon a number of factors, including the progress of our marketing programs, capital spending requirements and developments in Internet commerce. We will have broad discretion in how we use the proceeds from this offering. You will not have the opportunity to evaluate the economic, financial or other information on which we base our decisions regarding how to use the proceeds from this offering, and we may spend these proceeds in ways that do not increase our operating results or market value. Pending our expenditure on any of these uses, we plan to invest the proceeds of this offering in short-term, investment-grade, interest-bearing securities. We cannot predict whether these investments will yield a favorable return. The market price of our stock may be particularly volatile because of the industry in which we operate. The market prices of the securities of Internet-related companies have been especially volatile and have experienced extreme volume fluctuations. Volatility in the market price of our stock could lead to claims against us, including securities class action litigation. If we were the object of any litigation, it could result in substantial costs and a diversion of our management's attention and resources. The trading price of our common stock could be subject to wide fluctuations in response to a number of factors, including: - actual or anticipated variations in quarterly results of operations; - the introduction of new or enhanced offerings by us or our competitors; - changes in financial estimates or recommendations by securities analysts; - conditions or trends in the Internet and online commerce industries; - changes in the market valuations of other Internet companies; - announcements by us of significant acquisitions, strategic partnerships, joint ventures or capital commitments; - additions or departures of key personnel; - sales of common stock; and - general political and economic conditions. In addition, the stock market in general, and the Nasdaq National Market and the market for Internet and technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of these companies. These broad market and industry factors may adversely affect the market price of our common stock, regardless of our operating performance. The trading prices of the stocks of many Internet and technology companies are at or near historical highs and reflect price-earnings ratios substantially above historical levels. These trading prices and price earnings ratios may not be sustained. In addition, our stock may not trade at the same levels as other Internet or Internet-related companies' stock. Our controlling stockholders may make decisions which you do not consider to be in your best interest. We anticipate that our principal stockholders, executive officers, directors and entities affiliated with them will beneficially own, in the aggregate, approximately % of our outstanding common stock following the completion of this offering. These stockholders will be able to exercise control over all matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying or preventing another entity from acquiring or merging with us. Please see "Management" and "Principal Stockholders" for detailed information on the beneficial ownership of the principal stockholders, executive officers, directors and affiliates. Anti-takeover provisions in our charter documents and Delaware law could delay, defer or prevent a tender offer or takeover attempt that you consider to be in your best interest. Anti-takeover provisions of our restated certificate of incorporation, our restated bylaws and Delaware law could make it more difficult for a third party to acquire us. As a result, we could delay, defer or prevent a takeover attempt or third party acquisition that our stockholders consider in their best interest, including an attempt that might result in a premium over the market price for the shares held by our stockholders. Please see "Description of Capital Stock" for detailed information on these provisions. You will suffer immediate and substantial dilution in the value of your shares. The initial public offering price of our common stock will be substantially higher than the net tangible book value per share of our common stock immediately after this offering. The exercise of outstanding options and warrants may result in further dilution. Please see "Dilution" for detailed information on dilution resulting from this offering.

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+RISK FACTORS This offering involves a high degree of risk. Investors should carefully consider the risks and uncertainties and the other information in this prospectus before deciding whether to invest in shares of our common stock. Any of the following risks could cause the trading price of our common stock to decline. RISKS RELATED TO OUR BUSINESS WE MAY NOT MEET QUARTERLY FINANCIAL EXPECTATIONS, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE. Our quarterly operating results are likely to vary significantly in the future based upon a number of factors related to our industry and the markets for our products, over many of which we have little or no control. We operate in a highly dynamic industry and future results could be subject to significant fluctuations, particularly on a quarterly basis. These fluctuations could cause us to fail to meet quarterly financial expectations, which could cause our stock price to decline rapidly and significantly. Factors contributing to the volatility of our stock price include: - the timing and success of new product and technology introductions by us or our competitors; - availability of raw materials, semiconductor wafers and manufacturing capacity or fluctuations in our manufacturing yields; - changes in selling prices for our integrated circuits due to competitive or currency exchange rate pressures; - changes in our product mix; - changes in the relative percentage of products sold through distributors as compared to direct sales; - market acceptance of our products; and - changes in customer purchasing cycles. Due to the factors discussed above, investors should not rely on quarter-to-quarter comparisons of our results of operations as indicators of future performance. OUR RELIANCE ON THIRD-PARTY WAFER FABS TO MANUFACTURE OUR SEMICONDUCTOR WAFERS MAY CAUSE A SIGNIFICANT DELAY IN OUR ABILITY TO FILL ORDERS AND LIMITS OUR ABILITY TO ASSURE PRODUCT QUALITY AND TO CONTROL COSTS. We do not own or operate a semiconductor fabrication facility. We currently rely on four third-party wafer fabs to manufacture substantially all of our semiconductor wafers. Each of these third-party wafer fabs is our sole source for wafers manufactured using a particular process technology. Substantially all of our products sold in 1999 and a majority of our products during the first three months of 2000 were manufactured in gallium arsenide by TRW. The supply agreement with TRW provides us with a guaranteed supply of wafers through December 31, 2000. We may not be able to negotiate an extension to this agreement on favorable terms, if at all. We also may not be successful in forming an alternative supply arrangement that provides us with a sufficient supply of gallium arsenide wafers. In addition, we have only recently begun working with two of our four principal third-party wafer fabs. The loss of one of our third-party wafer fabs, in particular TRW, or any delay or reduction in wafer supply will impact our ability to fulfill customer orders, perhaps materially, and could damage our relationships with our customers, either of which would significantly harm our business and operating results. Because there are limited numbers of third-party wafer fabs that use the particular process technologies we select for our products and that have sufficient capacity to meet our needs, using alternative or additional third-party wafer fabs would require an extensive qualification process that could prevent or delay product shipments. Our reliance on these third-party wafer fabs involves several additional risks, including reduced control over the manufacturing costs, delivery times, reliability and quality of our components produced from these wafers. The fabrication of semiconductor wafers is a highly complex and precise process. Minute impurities, difficulties in the fabrication process, defects in the masks used to print circuits on a wafer, wafer breakage or other factors can cause a substantial percentage of wafers to be rejected or numerous die on each wafer to be nonfunctional. We expect that our customers will continue to establish demanding specifications for quality, performance and reliability that must be met by our products. Our third-party wafer fabs may not be able to achieve and maintain acceptable production yields in the future. These risks are heightened with respect to our two newest third-party wafer fabs which have not yet produced wafers in volume for us. To the extent our third-party wafer fabs suffer failures or defects, we could experience lost revenues, increased costs, and delays in, cancellations or rescheduling of orders or shipments, any of which would harm our business. In the past, we have experienced delays in product shipments from our third-party wafer fabs, which in turn delayed product shipments to our customers. We may in the future experience similar delays or other problems, such as inferior wafer quality, reduced manufacturing yields and inadequate wafer supply. OUR RELIANCE ON SUBCONTRACTORS TO PACKAGE OUR PRODUCTS COULD CAUSE A DELAY IN OUR ABILITY TO FULFILL ORDERS OR COULD INCREASE OUR COST OF REVENUES. We do not package the RF components that we sell but rather rely on subcontractors to package our products. Packaging is the procedure of electrically bonding and encapsulating the integrated circuit into its final protective plastic or ceramic casing. We provide the wafers containing the integrated circuits and, in some cases, packaging materials to third-party packagers. Although we currently work with five packagers, substantially all of our net revenues in 1999 and the first three months of 2000 were attributable to products packaged by one subcontractor, MPI Corporation of Manila, Philippines. A relative of one of our principal stockholders controls MPI. We do not have long-term contracts with our third-party packagers stipulating fixed prices or packaging volumes. Therefore, in the future we may be unable to obtain sufficient high quality or timely packaging of our products. The loss or reduction in packaging capacity of any of our current packagers, particularly MPI, would significantly damage our business. In addition, increased packaging costs will adversely affect our profitability. The fragile nature of the semiconductor wafers that we use in our components requires sophisticated packaging techniques and can result in low packaging yields. If our packaging subcontractors fail to achieve and maintain acceptable production yields in the future, we could experience increased costs, including warranty expense and costs associated with customer support, delays in or cancellations or rescheduling of orders or shipments, product returns or discounts and lost revenues, any of which would harm our business. WE DEPEND ON TWO DISTRIBUTORS FOR A SIGNIFICANT PORTION OF OUR SALES, THE LOSS OF ANY ONE OF WHICH WOULD LIMIT OUR ABILITY TO SUSTAIN AND GROW OUR REVENUES. Historically, two distributors, Avnet Electronics Marketing and Richardson Electronics, have accounted for a significant portion of our sales. In 1999, sales through Richardson Electronics represented 38% of our net revenues and sales through Avnet Electronics Marketing represented 13% of our net revenues. In the three months ended March 31, 2000, sales through Richardson Electronics represented 39% of our net revenues and sales through Avnet Electronics Marketing represented 24% of our net revenues. These distributors principally purchase our standard components for resale to their customers. Our contracts with these distributors do not require them to purchase our products and may be terminated by them at any time without penalty. If our distributors fail to successfully market and sell our products, our revenues could be materially adversely affected. The loss of either of our current distributors and our failure to develop new and viable distribution relationships would limit our ability to sustain and grow our revenues. WE DEPEND ON MINICIRCUITS LABORATORIES FOR A SUBSTANTIAL PORTION OF OUR REVENUES AND THE LOSS OF MINICIRCUITS AS A CUSTOMER OR A DECREASE IN PURCHASES BY MINICIRCUITS WOULD ADVERSELY AFFECT OUR REVENUES. Sales to Minicircuits Laboratories, a private label reseller of our products, account for a significant portion of our revenues. For example, 36% of our net revenues in 1998, 41% of our net revenues in 1999 and 31% of our net revenues in the three months ended March 31, 2000 were attributable to sales to Minicircuits. We expect that we will continue to rely on sales to Minicircuits for a significant portion of our future revenues. In addition to reselling products of Stanford Microdevices and other RF component suppliers, Minicircuits also designs and supplies their own RF components. Our current contract with Minicircuits does not require Minicircuits to purchase our products in the future. If we were to lose Minicircuits as a customer, or if Minicircuits substantially reduced its purchases, our business and operating results would be adversely affected. STANFORD UNIVERSITY HAS FILED A LAWSUIT AGAINST US ALLEGING TRADEMARK INFRINGEMENT. IF THIS LAWSUIT IS DECIDED AGAINST US, WE COULD BE FORCED TO CHANGE OUR CORPORATE NAME, LOSE BRAND RECOGNITION, PAY DAMAGES AND INCUR SIGNIFICANT LITIGATION COSTS. On March 17, 2000, Stanford University filed a complaint against us in the United States District Court for the Northern District of California alleging, among other things, infringement by us of its trademark by our use of the name "Stanford" and by use of any logo containing the letter "S" on a red background. Stanford University has requested preliminary and permanent injunctions prohibiting us from infringing its trademark, and seeks compensatory damages, exemplary and punitive damages, costs and attorneys' fees. A hearing on Stanford University's request for a preliminary injunction was held by the District Court on May 8, 2000 and Stanford University was denied the preliminary injunction. Stanford University then filed a motion with the District Court for an emergency injunction pending appeal and on May 16, 2000 Stanford University was denied the emergency injunction. Stanford University has filed a notice of appeal to the United States Court of Appeals for the Ninth Circuit from the denial of the preliminary injunction and has filed a motion with the Court of Appeals for an emergency injunction pending the appeal. Even though we have thus far successfully defeated requests for injunctions, if we ultimately lose the appeal from the denial of the preliminary injunction or the lawsuit, we may be prohibited from using our logo and/or corporate name. If we are prohibited from using our name or logo, our brand recognition that we have built over several years could be significantly impaired, which could severely damage our business and operating results. We would also need to invest significant capital in rebranding our products and, in general, our company. In addition, we may be liable for monetary damages and other costs of litigation. Even if we are entirely successful in defending the lawsuit, we may incur significant legal expenses and our management may expend significant time in the defense. See "Business -- Legal Proceedings" for a description of this litigation. INTENSE COMPETITION IN OUR INDUSTRY COULD PREVENT US FROM INCREASING REVENUES AND SUSTAINING PROFITABILITY. The RF semiconductor industry is intensely competitive and is characterized by the following: - rapid technological change; - rapid product obsolescence; - shortages in wafer fabrication capacity; - price erosion; and - unforeseen manufacturing yield problems. We compete primarily with other suppliers of high-performance RF components used in the infrastructure of communications networks such as Agilent, Alpha Industries, Anadigics, Conexant, Infineon, M/A-COM, Minicircuits Laboratories, NEC, RF Micro Devices, TriQuint Semiconductor and Watkins-Johnson. We also compete with communications equipment manufacturers who manufacture RF components internally such as Ericsson, Lucent, Motorola and Nortel Networks. We expect increased competition both from existing competitors and from a number of companies that may enter the RF component market, as well as future competition from companies that may offer new or emerging technologies. In addition, many of our current and potential competitors have significantly greater financial, technical, manufacturing and marketing resources than we have. As a result, communications equipment manufacturers may decide not to buy from us due to their concerns about our size, financial stability or ability to interact with their logistics systems. Our failure to successfully compete in our markets would have a material adverse effect on our business, financial condition and results of operations. OUR BUSINESS STRATEGY IS DEPENDENT ON SUCCESSFUL MARKETING AND SALES OF RF COMPONENTS PRODUCED USING THREE PROCESS TECHNOLOGIES WITH WHICH WE HAVE LIMITED EXPERIENCE. We shipped our first products using silicon germanium and indium gallium phosphide in the fourth quarter of 1999. In addition, although we plan to act as a reseller of products manufactured using the laterally diffused metal oxide semiconductor process, we have not yet generated any revenues from resale of these products. As a result, investors have a very limited basis upon which to evaluate the demand for, and market acceptance of, our products manufactured using these technologies. If our products using these technologies do not meet customer expectations or if the market for these products fails to develop or develops more slowly than we expect, our business would be harmed. IF WE FAIL TO INTRODUCE NEW PRODUCTS IN A TIMELY AND COST-EFFECTIVE MANNER, OUR ABILITY TO SUSTAIN AND INCREASE OUR REVENUES COULD SUFFER. The markets for our products are characterized by frequent new product introductions, evolving industry standards and changes in product and process technologies. Because of this, our future success will in large part depend on: - our ability to continue to introduce new products in a timely fashion; - our ability to improve our products and to adapt to new process technologies in a timely manner; - our ability to adapt our products to support emerging and established industry standards; and - market acceptance of our products. We estimate that the development cycles of our products from concept to production could last up to 12 months. We have in the past experienced delays in the release of new products. We may not be able to introduce new products in a timely and cost-effective manner which would impair our ability to sustain and increase our revenues. PRODUCT QUALITY, PERFORMANCE AND RELIABILITY PROBLEMS COULD DISRUPT OUR BUSINESS AND HARM OUR FINANCIAL CONDITION. Our customers demand that our products meet stringent quality, performance and reliability standards. RF components such as those we produce may contain undetected defects or flaws when first introduced or after commencement of commercial shipments. We have from time to time experienced product quality, performance or reliability problems. In addition, some of our products are manufactured using process technologies that are relatively new and for which long-term field performance data are not available. As a result, defects or failures may occur in the future relating to our product quality, performance and reliability. If these failures or defects occur, we could experience lost revenues, increased costs, including warranty expense and costs associated with customer support, delays in or cancellations or rescheduling of orders or shipments and product returns or discounts, any of which would harm our business. SOURCES FOR CERTAIN COMPONENTS AND MATERIALS ARE LIMITED, WHICH COULD RESULT IN DELAYS OR REDUCTIONS IN PRODUCT SHIPMENTS. The semiconductor industry from time to time is affected by limited supplies of certain key components and materials. For example, we rely on limited sources for certain packaging materials. If we, or our packaging subcontractors, are unable to obtain these or other materials in the required quantity and quality, we could experience delays or reductions in product shipments, which would materially and adversely affect our profitability. Although we have not experienced any significant difficulty to date in obtaining these materials, these shortages may arise in the future. We cannot guarantee that we would not lose potential sales if key components or materials are unavailable, and as a result, we are unable to maintain or increase our production levels. IF COMMUNICATIONS EQUIPMENT MANUFACTURERS INCREASE THEIR INTERNAL PRODUCTION OF RF COMPONENTS, OUR REVENUES WOULD DECREASE AND OUR BUSINESS WOULD BE HARMED. Currently, communications equipment manufacturers obtain their RF components by either developing them internally or by buying widely available standard RF components from third-party distributors. We have historically generated substantially all of our revenues through sales of standard components to these manufacturers through our distributors. If communications equipment manufacturers increase their internal production of RF components and reduce purchases of RF components from third parties, our revenues would decrease and our business would be harmed. WE HAVE RECENTLY ESTABLISHED A BUSINESS UNIT FOCUSED ON DESIGNING RF COMPONENTS FOR SPECIFIC EQUIPMENT MANUFACTURERS. OUR FAILURE TO GROW THIS BUSINESS UNIT WOULD IMPAIR OUR ABILITY TO SUSTAIN AND INCREASE OUR REVENUES. Communications equipment manufacturers have begun to work directly with component suppliers such as us to design and build customized products for specific needs. We have recently established a business unit focused on designing RF components to meet these needs. Our business strategy is dependent in part on this business unit to sustain and increase our revenues. This business unit has not yet completed development of or shipped any products and we cannot guarantee that we will be successful in developing this business unit. Development of this business unit will require us to expand our internal sales force and successfully install logistic and supply chain software and processes to manage this business unit. Each of these tasks will require significant management attention and expenditure of resources. Even with this attention and these expenditures, we may be unsuccessful in operating this business unit and this business unit may not generate any revenues. We may spend considerable sums developing components for a particular application or a potential customer. We do not expect that these customers will have any contractual obligation to purchase these products and we many never realize any revenues from sales of these products. In addition, if the recent trend of outsourcing the design and manufacture of customized components to third parties is reversed, we would not be able to execute this element of our business strategy. THIRD-PARTY WAFER FABS WHO MANUFACTURE THE SEMICONDUCTOR WAFERS FOR OUR PRODUCTS MAY COMPETE WITH US IN THE FUTURE. Several third-party wafer fabs independently produce and sell RF components directly to communications equipment manufacturers. We currently rely on certain of these third-party wafer fabs to produce the semiconductor wafers for our products and, in the case of UltraRF, for the production of the RF components which we plan to resell to communications equipment manufacturers. These third-party wafer fabs possess confidential information concerning our products and product release schedules. We cannot guarantee that they would not use our confidential information to compete with us. Competition from these third-party wafer fabs may result in reduced demand for our products and could damage our relationships with these third-party wafer fabs, thereby harming our business. PERCEIVED RISKS RELATING TO PROCESS TECHNOLOGIES WE MAY ADOPT IN THE FUTURE TO MANUFACTURE OUR PRODUCTS COULD CAUSE RELUCTANCE AMONG POTENTIAL CUSTOMERS TO PURCHASE OUR PRODUCTS. We may adopt new process technologies in the future to manufacture our products. Prospective customers of these products may be reluctant to purchase these products based on perceived risks of these new technologies. These risks could include concerns related to manufacturing costs and yields and uncertainties about the relative cost-effectiveness of products produced using these new technologies. If our products fail to achieve market acceptance, our business, financial condition and results of operations would be materially adversely affected. WE MAY ENCOUNTER DIFFICULTIES IN MANAGING OUR GROWTH. We are experiencing a period of rapid growth and expansion that will continue to place a significant strain on our management and other resources. The number of our employees has increased from 24 at December 31, 1998 to 77 at December 31, 1999 and 91 at March 31, 2000. To accommodate this growth, we must implement a variety of new and upgraded operational and financial systems, procedures and controls, including the improvement of the accounting and other internal management systems. This may require substantial managerial and financial effort, and our efforts in this regard may not be successful. Our current systems, procedures and controls may not be adequate to support our operations. If we fail to improve our operational, financial and management information systems, or fail to effectively motivate or manage our new and future employees, our business could be harmed. Several members of our senior management joined us in 1999, including Robert Van Buskirk, our President and Chief Executive Officer, and Thomas Scannell, our Vice President, Finance and Administration and Chief Financial Officer. We cannot guarantee that our management team will be able to continue to work together effectively or manage our growth successfully. IF WE LOSE OUR KEY PERSONNEL OR ARE UNABLE TO ATTRACT AND RETAIN KEY PERSONNEL, WE MAY BE UNABLE TO PURSUE BUSINESS OPPORTUNITIES OR DEVELOP OUR PRODUCTS. We believe that our future success will depend in large part upon our continued ability to recruit, hire, retain and motivate highly skilled technical, marketing and managerial personnel, who are in great demand. Competition for these employees, particularly RF integrated circuit design engineers, is intense. Our failure to hire additional qualified personnel in a timely manner and on reasonable terms could adversely affect our business and profitability. In addition, from time to time we may recruit and hire employees from our customers, suppliers and distributors, which could damage our business relationship with these parties. Our success also depends on the continuing contributions of our senior management and technical personnel, all of whom would be difficult to replace. The loss of key personnel could adversely affect our ability to execute our business strategy, which could cause our results of operations and financial condition to suffer. We may not be successful in retaining these key personnel. OUR LIMITED ABILITY TO PROTECT OUR PROPRIETARY INFORMATION AND TECHNOLOGY MAY ADVERSELY AFFECT OUR ABILITY TO COMPETE. Our future success and ability to compete is dependent in part upon our proprietary information and technology. None of our technology is currently patented. Instead, we rely on a combination of contractual rights and copyright, trademark and trade secret laws and practices to establish and protect our proprietary technology. We generally enter into confidentiality agreements with our employees, consultants, resellers, wafer suppliers, customers and potential customers, and strictly limit the disclosure and use of other proprietary information. The steps taken by us in this regard may not be adequate to prevent misappropriation of our technology. Additionally, our competitors may independently develop technologies that are substantially equivalent or superior to our technology. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain or use our products or technology. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. OUR PRODUCTS COULD INFRINGE THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, AND RESULTING CLAIMS AGAINST US COULD BE COSTLY AND REQUIRE US TO ENTER INTO DISADVANTAGEOUS LICENSE OR ROYALTY ARRANGEMENTS. The semiconductor industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of intellectual property rights. Although we attempt to avoid infringing known proprietary rights of third parties in our product development efforts, we expect that we may be subject to legal proceedings and claims for alleged infringement by us or our licensees of third-party proprietary rights, such as patents, trade secrets, trademarks or copyrights, from time to time in the ordinary course of business. Any claims relating to the infringement of third-party proprietary rights, even if not meritorious, could result in costly litigation, divert management's attention and resources, or require us to enter into royalty or license agreements which are not advantageous to us. In addition, parties making these claims may be able to obtain an injunction, which could prevent us from selling our products in the United States or abroad. We may increasingly be subject to infringement claims as the number of our products grows. OUR RELIANCE ON FOREIGN SUPPLIERS AND MANUFACTURERS EXPOSES US TO THE ECONOMIC AND POLITICAL RISKS OF THE COUNTRIES IN WHICH THEY ARE LOCATED. Independent third parties in other countries package all of our products and supply some of our wafers and substantially all of the packaging materials used in the production of our components. Due to our reliance on foreign suppliers and packagers, we are subject to the risks of conducting business outside the United States. These risks include: - unexpected changes in, or impositions of, legislative or regulatory requirements; - shipment delays, including delays resulting from difficulty in obtaining export licenses; - tariffs and other trade barriers and restrictions; - political, social and economic instability; and - potential hostilities and changes in diplomatic and trade relationships. In addition, we currently transact business with our foreign suppliers and packagers in U.S. dollars. Consequently, if the currencies of our suppliers' countries were to increase in value against the U.S. dollar, our suppliers may attempt to raise the cost of our wafers, packaging materials, and packaging services, which could have an adverse effect on our profitability. A SIGNIFICANT PORTION OF OUR PRODUCTS ARE SOLD TO INTERNATIONAL CUSTOMERS EITHER THROUGH OUR DISTRIBUTORS OR DIRECTLY BY US, WHICH EXPOSES US TO RISKS THAT MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS. A significant portion of our direct sales and sales through our distributors were to foreign purchasers, particularly in countries located in Asia. International direct sales approximated 2% of our total direct sales for the year ended December 31, 1999. Based on information available from our distributors, products representing approximately 43% of our total distribution revenues, representing approximately 22% of our net revenues, were sold by our distributors to international customers in 1999. Demand for our products in foreign markets could decrease, which could have a materially adverse effect on our results of operations. Therefore, our future operating results may depend on several economic conditions in foreign markets, including: - changes in trade policy and regulatory requirements; - fluctuations in currency; - duties, tariffs and other trade barriers and restrictions; - trade disputes; and - political instability. ANY FUTURE ACQUISITIONS OF COMPANIES OR TECHNOLOGIES MAY RESULT IN DISTRACTION OF OUR MANAGEMENT AND DISRUPTIONS TO OUR BUSINESS. We may acquire or make investments in complementary businesses, technologies, services or products if appropriate opportunities arise. From time to time, we may engage in discussions and negotiations with companies regarding our acquiring or investing in their businesses, products, services or technologies. We may not be able to identify suitable acquisition or investment candidates in the future, or if we do identify suitable candidates, we may not be able to make such acquisitions or investments on commercially acceptable terms or at all. If we acquire or invest in another company, we could have difficulty assimilating that company's personnel, operations, technology or products and service offerings. In addition, the key personnel of the acquired company may decide not to work for us. These difficulties could disrupt our ongoing business, distract our management and employees, increase our expenses and adversely affect our results of operations. Furthermore, we may incur indebtedness or issue equity securities to pay for any future acquisitions. The issuance of equity securities could be dilutive to our existing stockholders. In addition, the accounting treatment for any acquisition transaction may result in significant goodwill, which, when amortized, will negatively affect our net income. As of the date of this prospectus, we have no agreement to enter into any investment or acquisition transaction. RISKS RELATED TO OUR INDUSTRY OUR GROWTH DEPENDS ON THE GROWTH OF THE INFRASTRUCTURE FOR WIRELESS AND WIRELINE COMMUNICATIONS. IF THIS MARKET DOES NOT CONTINUE TO GROW, OR IF IT GROWS AT A SLOW RATE, DEMAND FOR OUR PRODUCTS WILL DIMINISH. Our success will depend in large part on the continued growth of the telecommunications industry in general and, in particular, the market for wireless and wireline infrastructure components. We cannot assure you that the market for these infrastructure products will continue to grow at historical rates or at all. Even if the demand for infrastructure grows, we will need to complete new product designs that meet the needs of our customers at a rate consistent with the growth of the market. Our product and process development efforts may not be successful in this regard. THE TIMING OF THE ADOPTION OF INDUSTRY STANDARDS MAY NEGATIVELY IMPACT WIDESPREAD MARKET ACCEPTANCE OF OUR PRODUCTS. The markets in which we and our customers compete are characterized by rapidly changing technology, evolving industry standards and continuous improvements in products and services. If technologies or standards supported by our or our customers' products become obsolete or fail to gain widespread commercial acceptance, our business will be significantly damaged. In addition, the increasing demand for wireless and wireline communications has exerted pressure on standards bodies worldwide to adopt new standards for these products, generally following extensive investigation of, and deliberation over, competing technologies. The delays inherent in the standards approval process may in the future cause the cancellation, postponement or rescheduling of the installation of communications systems by our customers. These delays may in the future have a material adverse effect on the sale of products by us and on our business, financial condition and results of operations. INDUSTRY-WIDE FLUCTUATIONS IN SUPPLY AND DEMAND FOR SEMICONDUCTOR PRODUCTS COULD ADVERSELY IMPACT OUR BUSINESS. The semiconductor industry has historically been characterized by wide fluctuations in supply and demand for semiconductor products. From time to time, demand for semiconductor products has decreased, often in connection with, or in anticipation of, major additions of wafer fabrication capacity or maturing product cycles or due to general economic conditions. In the past, diminished product demand, production overcapacity and subsequent accelerated price erosion have lasted for extended periods of time. These fluctuations may occur in the future and could materially and adversely impact our business. RISKS RELATED TO THIS OFFERING OUR STOCK PRICE MAY BE EXTREMELY VOLATILE. Our common stock has never been sold in a public market and an active trading market for our common stock may not develop or be sustained upon the completion of this offering. We are negotiating the initial public offering price of the common stock with the underwriters. However, the initial public offering price may not be indicative of the prices that will prevail in the public market after the offering, and the market price of the common stock could fall below the initial public offering price. Investors should read the "Underwriting" section for a discussion of the factors considered in determining the initial public offering price. In addition, the market price of our common stock could fluctuate widely in response to the following factors: - actual or anticipated variations in operating results; - announcements of technological innovations, new products or new services by us or by our competitors or customers; - changes in financial estimates or recommendations by stock market analysts regarding us or our competitors; - announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments; - additions or departures of key personnel; - future equity or debt offerings or our announcements of these offerings; and - general market and economic conditions. In addition, in recent years, the stock market in general, and the Nasdaq National Market and the securities of technology companies in particular, have experienced extreme price and volume fluctuations. These fluctuations have often been unrelated or disproportionate to the operating performance of individual companies. These broad market fluctuations may materially adversely affect our stock price, regardless of our operating results. WE MAY INVEST OR SPEND THE PROCEEDS OF THIS OFFERING IN WAYS WITH WHICH INVESTORS MAY NOT AGREE AND IN WAYS THAT MAY NOT YIELD A FAVORABLE RETURN. We will retain broad discretion over the use of proceeds from this offering. Stockholders may not deem the actual uses desirable, and our use of the proceeds may not yield a significant return or any return at all. We intend to use the proceeds from this offering for research and development, working capital and other general corporate purposes and to finance potential acquisitions and investments. Because of the number and variability of factors that determine our use of the net proceeds from this offering, we cannot guarantee that these uses will not vary substantially from our currently planned uses. SOME OF OUR EXISTING STOCKHOLDERS CAN EXERT CONTROL OVER US, AND THEY MAY NOT MAKE DECISIONS THAT REFLECT THE INTERESTS OF STANFORD MICRODEVICES OR OTHER STOCKHOLDERS. After this offering, our officers, directors and principal stockholders (greater than 5% stockholders) will together control approximately 78.4% of our outstanding common stock and our two founding stockholders will control 54.7% of our outstanding common stock. As a result, these stockholders, if they act together, and our founding stockholders acting alone, will be able to exert a significant degree of influence over our management and affairs and control matters requiring stockholder approval, including the election of all of our directors and approval of significant corporate transactions. In addition, this concentration of ownership may delay or prevent a change in control of Stanford Microdevices and might affect the market price of our common stock. In addition, the interests of these stockholders may not always coincide with the interests of Stanford Microdevices or the interests of other stockholders. OUR CHARTER AND BYLAWS AND DELAWARE LAW CONTAIN PROVISIONS THAT MAY DELAY OR PREVENT A CHANGE OF CONTROL. Provisions of our charter and bylaws may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions include: - division of the board of directors into three separate classes; - elimination of cumulative voting in the election of directors; - prohibitions on our stockholders from acting by written consent and calling special meetings; - procedures for advance notification of stockholder nominations and proposals; and - the ability of the board of directors to alter our bylaws without stockholder approval. In addition, our board of directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by the stockholders. The issuance of preferred stock, while providing flexibility in connection with possible financings or acquisitions or other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We are also subject to Section 203 of the Delaware General Corporation Law that, subject to exceptions, prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years following the date that this stockholder became an interested stockholder. The preceding provisions of our charter and bylaws, as well as Section 203 of the Delaware General Corporation Law, could discourage potential acquisition proposals, delay or prevent a change of control and prevent changes in our management. SOME PURCHASERS OF SHARES IN THIS OFFERING HAVE THE RIGHT TO RESCIND THEIR PURCHASE OF THE SHARES, WHICH WOULD REDUCE THE NET PROCEEDS TO BE RECEIVED BY US IN THIS OFFERING AND COULD HARM OUR BUSINESS, RESULTS OF OPERATIONS AND FINANCIAL CONDITION. Prior to the effectiveness of the registration statement covering the shares being sold in this offering, one of our officers provided written materials to 21 individuals who we have designated as potential purchasers of up to 37,000 shares in this offering through a directed share program. These materials may constitute a prospectus that does not meet the requirements of the Securities Act of 1933. The persons who received these written materials should rely only on the disclosure contained in this prospectus and should not rely upon the previously provided written materials in any manner in making a decision whether to purchase shares in this offering. If the distribution of these materials by us did constitute a violation of the Securities Act of 1933, the recipients of these materials who purchase shares in this offering would have the right, for a period of one year from the date of their purchase of the shares, to obtain recovery of the consideration paid in connection with their purchase of shares or, if they had already sold the shares, sue us for damages resulting from their purchase of shares. These damages could total up to approximately $481,000 plus interest, based on an assumed initial public offering price of $13.00 per share, if these investors seek recovery or damages after an entire loss of their investment. If this occurs, our business, results of operations and financial condition could be harmed. FUTURE SALES OF OUR COMMON STOCK MAY DEPRESS OUR STOCK PRICE. The market price of our common stock could decline as a result of sales by our existing stockholders of a large number of shares of our common stock in the market after this offering or the perception that such sales could occur. These sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. Please see "Shares Eligible for Future Sale" for a description of sales that may occur in the future. WE DO NOT INTEND TO PAY DIVIDENDS ON OUR COMMON STOCK. We currently intend to retain any future earnings for funding growth and, therefore, do not anticipate paying any dividends in the foreseeable future. INVESTORS IN THIS OFFERING WILL SUFFER IMMEDIATE AND SUBSTANTIAL DILUTION. We expect the initial public offering to be substantially higher than the net tangible book value per share of our common stock. The net tangible book value of a share of common stock purchased at an assumed initial public offering price of $13.00 per share will be only $2.35. Additional dilution may be incurred if holders of options to purchase our common stock, whether currently outstanding or subsequently granted, exercise their options.

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+RISK FACTORS Before you invest in our common stock, you should understand the high degree of risk involved. You should consider carefully the following risks and other information in this prospectus, including our combined financial statements and related notes, before you decide to purchase shares of our common stock. If any of the following risks actually occur, our business, financial condition and operating results could be adversely affected. As a result, the trading price of our common stock could decline and you may lose part or all of your investment. RISKS RELATED TO OUR BUSINESS OUR LIMITED OPERATING HISTORY MAKES AN EVALUATION OF OUR BUSINESS AND OUR PROSPECTS DIFFICULT. Our predecessor company has operated since January 1997. We were incorporated in connection with a series of corporate transactions in June 1999 and have a limited operating history. Prior to investing in our common stock, you should consider the risks and difficulties that we face as an early stage company with an unproven business model in a new and rapidly evolving e-commerce market. Some of these specific risks and difficulties include: - we depend substantially on an Internet-based trading exchange that has been present in the market for a limited time and may not be successful; - we depend substantially on commissions generated from purchases and sales of commodity chemicals, plastics and fuel products on our trading exchange and we may be unable to significantly increase revenues from these commissions or generate revenues from other sources; - we may be unable to significantly increase and maintain industry adoption and use of our Internet-based solution for purchasing and selling commodity chemicals, plastics and fuel products; - we may be unable to develop and enhance the CheMatch.com brand; - we may be unable to maintain existing or establish new relationships with purchasers and sellers of commodity chemicals, plastics and fuel products; - we may be unable to adapt to rapidly changing technologies and developing markets; - we may be unable to effectively manage our rapidly expanding operations and the increasing use of our trading exchange and related services; and - we may be unable to attract, retain and motivate qualified personnel, particularly people who understand our trading exchange and the industries and products represented on it. We have generated only immaterial revenues to date. Due to our limited operating history, we believe that period-to-period comparisons of our revenues and results of operations are not meaningful. As a result, you should not rely on our revenues or results of operations for any prior period as an indication of our future performance or prospects. WE HAVE A HISTORY OF LOSSES AND EXPECT FUTURE LOSSES. We have had substantial losses since our inception. We currently expect our losses to increase in the future, and we cannot assure you that we will ever achieve or sustain profitability. From June 21, 1999 through December 31, 1999, we incurred a net loss of $8.4 million. During the six months ended June 30, 2000, we had a net loss of $14.9 million. The extent of future losses will depend, in part, on the amount of growth in our revenue, which will depend primarily upon commissions generated from the increased adoption of our trading exchange by companies in the chemical industry. The extent of these losses will also depend, in part, on the amount of growth in our operating expenses, which we plan to increase. If our revenues grow more slowly than we anticipate, or our operating expenses increase without a corresponding increase in our revenues, or we fail to keep operating expense levels down, the imbalance between revenues and operating expenses will negatively affect our business, revenues, results of operations and financial condition. OUR BUSINESS MODEL IS UNPROVEN AND MAY NOT BE SUCCESSFUL. Our business-to-business Internet-based model is based on the establishment of our trading exchange as a viable alternative to the traditional methods of transacting business for purchasers and sellers of commodity chemicals, plastics and fuel products such as using phone brokers or contacting multiple parties to find the best prices. This business model is new and not proven. We cannot be certain that our business model will be successful or that we can achieve or sustain revenue growth or generate any profits. We must develop and market our trading exchange and achieve broad market acceptance by the chemical industry for our business model to succeed. We cannot be certain that a market for business-to-business commerce on the Internet generally, or our marketplace in particular, will emerge, grow or be sustainable. For example, industry participants may not adopt an Internet-based solution because of their comfort with traditional purchasing and selling habits and long-term relationships, the costs and resources required to switch trading methods, the need for products not offered on our trading exchange, security and privacy concerns, or general reticence about technology or the Internet. WE MAY NOT BE ABLE TO ATTRACT A SUFFICIENT NUMBER OF PURCHASERS AND SELLERS TO OUR EXCHANGE TO GENERATE LIQUIDITY IN THE PRODUCTS TRADED ON OUR EXCHANGE. Our business model depends in part on our ability to attract a sufficient number of purchasers and sellers of commodity chemicals, plastics and fuel products to create adequate liquidity in the products traded on our exchange. Our current and prospective members must perceive value in our marketplace which, in large part, depends upon the breadth of the products available for trading on our exchange and the services we provide. A key component of our strategy is creating a network effect, where the value to purchasers and sellers increases as the number of members to our marketplace increases. If we are unable to increase the number of purchasers and sellers in our marketplace by drawing new members, we will not be able to benefit from this network effect. As a result, the overall value of our Internet-based solution would be harmed, which would negatively affect our business, revenues, results of operations and financial condition. OUR SALES CYCLE IS LONG AND UNCERTAIN AND MAY NOT RESULT IN REVENUES. A significant amount of time may elapse from the time we make initial contact with a company we have targeted as a potential member of our marketplace and the time that company executes a membership agreement enabling it to trade on our exchange. Our membership agreement does not obligate our members to trade on our exchange and its execution may not result in future revenues. Further, we must educate our current and potential members on the use and benefits of our online marketplace. We need to spend a significant amount of time with multiple decision makers in a prospective member's organization to sell our marketplace. If we are unable to attract new members willing to adopt our marketplace for trading commodity chemicals, plastics and fuel products and purchase the services we offer, then our business will be adversely affected. IF THE TRANSACTION VOLUME ON OUR TRADING EXCHANGE DOES NOT GROW, IT IS UNLIKELY THAT WE WILL EVER ACHIEVE OR MAINTAIN PROFITABILITY. We depend heavily on commissions generated from purchases and sales of commodity chemicals, plastics and fuel products on our trading exchange. From February 1998 through June 30, 2000, 79 of our members completed a trade on our trading exchange. These members have completed 332 transactions. Our business model calls for a majority of our revenues in the future to be generated from transactions completed on our trading exchange. Our inability to increase the number of transactions completed on our trading exchange will negatively affect our business, revenues, results of operations and financial condition. WE HAVE PROVIDED SOME OF OUR MEMBERS WITH INCENTIVES TO TRADE ON OUR EXCHANGE THAT MAY HAVE THE EFFECT OF TEMPORARILY INCREASING THE LEVEL OF ACTIVITY ON OUR TRADING EXCHANGE WITHOUT CORRESPONDING REVENUES. We have provided some of our members with trading concessions and other incentives to transact business on our trading exchange. In addition, some of our strategic alliance agreements provide our strategic allies with trading concessions in future periods to encourage their use of our exchange. In the near term, these concessions and incentives may temporarily increase the level of activity on our trading exchange without generating a corresponding increase in revenue. Additionally, these companies may discontinue their support or use of our trading exchange when these agreements expire or are terminated. Of the 79 members who have completed trades on our exchange through June 30, 2000, fourteen have received discounts or other incentives of varying levels to transact business on our exchange. A SIGNIFICANT PORTION OF OUR REVENUES ARE CURRENTLY GENERATED FROM A RELATIVELY SMALL NUMBER OF MEMBERS. In fiscal 1999, three of our members accounted for more than 38% of our trading exchange revenues and, in the three months ended December 31, 1999, five of our members accounted for more than 62% of our trading exchange revenues. During the six months ended June 30, 2000, five of our members accounted for approximately 37% of our trading exchange revenues. We may continue to derive a significant portion of our revenues from a relatively small number of members. The loss of any of these members may adversely affect our business, results of operations or financial condition. DURING THE LAST FISCAL YEAR, MORE THAN TWO-THIRDS OF THE TRANSACTION VOLUME ON OUR EXCHANGE INVOLVED BENZENE; IF WE ARE NOT ABLE TO INCREASE MARKET PENETRATION IN OTHER PRODUCTS WE MAY FAIL. In fiscal 1999, approximately 69% of the physical transaction volume of trades on our exchange involved benzene. In the six months ended June 30, 2000, approximately 39% of the physical transaction volume of trades involved benzene. We may continue to derive a significant portion of our revenues from trades involving benzene. If a diversity of commodity chemicals, plastics and fuel products are not traded on our exchange, our business may not be successful. WE MAY NOT BE ABLE TO COMPETE AGAINST OUR ONLINE COMPETITORS AND OTHER LARGE AND EMERGING COMPANIES. The market for Internet-based, business-to-business commerce solutions is extremely competitive. Our online competitors include Autobase Information Systems Inc. (efuel.com), ChemConnect, Inc., ChemCross.com, Inc., Commerce One, Inc., Commerx, Inc. (PlasticsNet.com), e-Chemicals Inc., ELEMICA.com, fob.com, FreeMarkets, Inc., PurchasePro.com., Inc., VerticalNet, Inc. and their respective affiliates. We may also face competition from large, established chemical companies. We expect competition to intensify as our current online competitors expand their product offerings. There are relatively low barriers to entry in our market. We expect additional competition from emerging or established companies to develop, and our members may adopt the solutions of these competitors as the cost of switching is low. We cannot assure you that we will be able to compete successfully against current or future competitors, or that competitive pressures we face will not harm our business, operating results or financial condition. OUR COMPETITORS MAY DEVELOP SOLUTIONS THAT ACHIEVE GREATER MARKET ACCEPTANCE THAN OUR MARKETPLACE. Our competitors may be able to negotiate alliances with strategic partners on more favorable terms than we are able to negotiate. Some of our strategic allies and other members have and others may in the future invest in our competitors and may reduce or discontinue their use or support of our marketplace. Our competitors may develop superior solutions that achieve greater market acceptance than our marketplace. Our members may adopt our competitors' solutions as the cost of switching is low. Further, some of these competitors have long operating histories in the chemical industry, greater name recognition, an established network of potential users and significantly greater financial, technical and marketing resources than we do. These companies would be able to undertake more extensive marketing campaigns for their Internet-based solution and adopt more aggressive pricing policies in attracting potential users of their solution. For these reasons, our ability to compete effectively against these enterprises is uncertain. THE SUCCESS OF OUR MARKETPLACE DEPENDS ON OUR ABILITY TO REMAIN NEUTRAL, AND IF WE ARE PERCEIVED TO FAVOR ONE MEMBER OVER ANOTHER, OUR MARKETPLACE MAY NOT ACHIEVE ACCEPTANCE. We must provide a neutral, unbiased marketplace to attract members to conduct business on our trading exchange. If members perceive that our marketplace favors certain members over others, or that a particular member could influence our marketplace, then our reputation could be damaged. This perception of bias may cause current and potential members to lose confidence in our marketplace and to conduct their business in other marketplaces. Upon completion of this offering, E.I. duPont de Nemours and Company will own 9.1% of our outstanding shares and such ownership may create the perception that we do not provide a neutral and unbiased marketplace. Any actual or perceived bias could negatively impact our ability to attract and maintain current and potential members. IF WE ARE UNABLE TO RESPOND TO RAPID TECHNOLOGICAL CHANGES ASSOCIATED WITH INTERNET-BASED SOLUTIONS, WE MAY LOSE MEMBERS TO OUR COMPETITORS. The market for our trading exchange is likely to be characterized by rapid technological advances in the hardware and software markets and changes in our members' and the market's requirements. As a result, our future success depends upon our ability to enhance our marketplace through technological advances and where necessary to adapt our trading exchange to our members' and the market's specific needs. If we are not able to maintain a reliable, scalable technology platform that can rapidly incorporate technological advances and that meets the needs of our members and the market, we may lose members to our competitors who are able to provide a technologically advanced solution that meets the needs of purchasers and sellers of commodity chemicals, plastics and fuel products. IF WE ARE NOT ABLE TO DETERMINE OR DESIGN THE FEATURES AND FUNCTIONALITY THAT COMPANIES REQUIRE OR PREFER, WE MAY NOT BE ABLE TO ATTRACT MEMBERS AND MAY LOSE CURRENT MEMBERS TO COMPETITORS. Our success depends upon our ability to accurately determine the features and functionality that our members require or prefer in a business-to-business Internet-based marketplace. We may lack the ability to successfully design and implement these features and functionality. We have designed our marketplace based upon internal design efforts and feedback from a relatively limited number of members. We cannot be certain, however, that the features and functionality we offer through our marketplace, or those that we may offer in future, will satisfy the requirements or preferences of our current or target members. If we are unable to determine or design the features and functionality that members require or prefer in a business-to-business Internet-based marketplace, we may not be able to attract members and may lose current members to our competitors who are able to provide those features and functionality. OUR MEMBERS MAY ABANDON OUR MARKETPLACE IF WE EXPERIENCE HARDWARE OR SOFTWARE FAILURES. A significant disruption in our trading exchange could seriously undermine our members' confidence in our business. Our members hold us to a high standard of reliability and performance. We have experienced brief service interruptions on our trading exchange. These interruptions undermine current and prospective members' confidence in the reliability of our marketplace. Operating a successful online marketplace requires the successful technical operation of an entire chain of software, hardware and telecommunications equipment. A failure of any element in this chain may partially or completely disrupt transactions on our exchange and access to our information resource center. We may have members operating outside North America who use older or inferior technologies, which may not operate properly. In addition, our hardware and software systems are vulnerable to interruption from power failures, telecommunications outages, network service outages and disruptions, natural disasters, and vandalism and other misconduct. If we experience hardware or software failures, our members may abandon our marketplace. IF WE DO NOT ADEQUATELY MAINTAIN OUR MEMBERS' CONFIDENTIAL INFORMATION, OUR REPUTATION COULD BE HARMED AND WE COULD INCUR LEGAL LIABILITY. Any breach of security relating to our members' confidential information could result in legal liability for us and a reduction in use of our trading exchange by our members, which could materially harm our business. Our personnel receive highly confidential information from our members that is stored in our files and on our computer systems. For example, we receive sensitive pricing and other information that could be valuable to our members' competitors if misappropriated. We enter into standard non-disclosure agreements with all of our members. Our security procedures may fail to adequately protect information that we are obligated to keep confidential. We may be unable to successfully adopt effective systems for maintaining confidential information. The risk of disclosing confidential information may grow as we add more members to our trading exchange. If we fail to adequately maintain our members' confidential information, some of our members could end their business relationships with us and we could be subject to legal liability. This would adversely affect our business, results of operations and financial condition. OUR NEW MANAGEMENT TEAM MAY NOT OPERATE EFFECTIVELY OR SUCCESSFULLY IMPLEMENT OUR BUSINESS PLAN. We have only recently assembled our management team and instituted a management control structure. Almost all of our executive officers have joined our management team since June 1999. We cannot guarantee that our new management team will be able to operate effectively or implement successfully our business model. Our new management team's ability to manage our growth depends upon many factors, including its ability to: - maintain appropriate procedures, policies and systems to ensure that our marketplace operates in accordance with our member's expectations; - satisfy our need for additional financing on reasonable terms; and - manage the costs associated with expanding our infrastructure, including our marketplace, personnel and facilities. If management cannot successfully execute our strategic initiatives, our business may not be successful. THE LOSS OF KEY PERSONNEL WOULD NEGATIVELY IMPACT OUR BUSINESS. Our expansion and development will be largely dependent upon the continued services of the following members of our new management team: Carl McCutcheon, our Chairman, President and Chief Executive Officer, Lawrance McAfee, our Executive Vice President and Chief Financial Officer, and our other senior executives. The loss of the services of Mr. McCutcheon, who has significant commodities trading experience or Mr. McAfee, who has significant experience in corporate finance and mergers and acquisitions, could have a material adverse effect on our business. CHARGES ASSOCIATED WITH OUR PAYMENT OF STOCK-BASED COMPENSATION WILL NEGATIVELY IMPACT OUR RESULTS OF OPERATIONS. As a result of stock options granted to employees, we expect to incur approximately $7 million of additional non-cash stock-based compensation charges in future periods based on an initial public offering price of $11.00 per share, which will negatively affect our operating results. The recognition of these non-cash charges will increase the net loss we report to the financial markets in future periods. OUR FUTURE SUCCESS DEPENDS ON OUR ABILITY TO ATTRACT, DEVELOP AND RETAIN QUALIFIED PERSONNEL. Our future success depends in large part on our ability to hire, train and retain qualified employees. Any inability to hire, train and retain a sufficient number of qualified employees could hinder the growth of our business. Skilled personnel are in short supply, and this shortage is likely to continue for some time. As a result, competition for these people is intense, and the industry turnover rate for them is high. Consequently, we may have difficulty hiring our desired numbers of qualified employees. Moreover, even if we are able to expand our employee base, the resources required to attract and retain employees may adversely affect our operating margins by increasing expenses associated with our employees. IF WE FAIL TO MANAGE OUR BUSINESS EFFECTIVELY, OUR REVENUES AND RESULTS OF OPERATIONS MAY NOT MEET MEMBER AND INVESTOR EXPECTATIONS. We have rapidly expanded our operations and may continue to do so. This growth has placed, and is expected to continue to place, a significant demand on our sales, marketing, managerial, operational, financial and other resources. If we cannot manage our growth effectively, it is likely that our revenues and results of operations will not meet investor expectations. From June 21, 1999 through June 30, 2000, we grew from 13 to 73 employees. We may hire additional new employees to support our business. Our current information systems, procedures and controls may not be adequate to support our operations which would hinder our ability to exploit the market for trading commodity chemicals, plastics and fuel products over the Internet. WE MAY NOT BE ABLE TO INTEGRATE SUCCESSFULLY BUSINESSES OR TECHNOLOGIES THAT WE MAY ACQUIRE IN THE FUTURE. We may acquire businesses, technologies, services or products that we believe are strategic to or complement our business-to-business Internet-based business model. We do not currently have any understandings, commitments or agreements with respect to any acquisition, nor are we currently pursuing any acquisition. We may not be able to identify, negotiate or finance any future acquisition successfully. Even if we do succeed in acquiring a business, technology, service or product, we have no experience in integrating an acquisition into our business. The process of integration may produce unforeseen operating difficulties and expenditures and may absorb significant attention of our management that would otherwise be available for the ongoing development of our business. Moreover, we may not achieve any of the benefits that we might anticipate from a future acquisition. If we make future acquisitions, we may issue shares of stock that dilute other stockholders, incur debt, assume contingent liabilities or create additional expenses related to amortizing goodwill and other intangible assets, any of which might harm our financial results and cause the price of our stock to decline. Any financing that we might need for future acquisitions may only be available to us on terms that restrict our business or that impose on us costs that reduce our net income. OUR INTERNATIONAL OPERATIONS WILL BE EXPENSIVE AND MAY NOT SUCCEED. We have limited experience in marketing, selling and supporting our marketplace in foreign countries. The acquisition and development of those skills may be more difficult or take longer than we anticipate, especially due to language barriers and the fact that the Internet infrastructure in foreign countries may be less developed than the Internet infrastructure in the United States. To date, we have not generated significant revenues from international members. We currently maintain international offices in Brussels, Belgium, Hong Kong, Manchester, England, Singapore, Tokyo, Japan and Zurich, Switzerland. We also have local representatives in Buccinasco, Italy, Madrid, Spain, Sao Paulo, Brazil, Seoul, Korea and Valencia, Venezuela. We intend to expand our international operations by opening additional international offices and hiring additional international management, sales, marketing and support personnel. We may be unable to successfully market, sell, and support our marketplace internationally. If we are unable to expand our international operations successfully and in a timely manner, our business could be seriously harmed. We will need to devote significant management and financial resources to our international expansion. In particular, we will have to attract and retain management, sales, marketing and support personnel for our international offices. Competition for personnel experienced in these areas is intense, and we may be unable to attract and retain qualified staff. OUR INTERNATIONAL OPERATIONS ARE SUBJECT TO A VARIETY OF RISKS THAT COULD HARM OUR FINANCIAL CONDITION AND OPERATING RESULTS. Our international operations are subject to a variety of additional risks that could seriously harm our financial condition and operating results. These risks include the following: - the establishment of a market for Internet-based trading of commodity chemicals and other products internationally; - global economic events; - fluctuations in foreign currencies; - unexpected changes in regulatory requirements; - longer payment cycles and problems collecting accounts receivable; - reduced protection for intellectual property and proprietary rights in some countries; and - seasonal fluctuations in business activity in some international regions. WE MAY NOT BE ABLE TO CONTINUE TO FACILITATE SWAP TRANSACTIONS ON OUR EXCHANGE, AND WE COULD BE EXPOSED TO CLAIMS BY OUR MEMBERS OR REGULATORY-IMPOSED FINES OR PENALTIES. We facilitate trading in financial derivatives known as swap agreements, in which the parties exchange cash payments with reference to changes in the price of a commodity or another agreed benchmark. The Commodity Exchange Act requires that trading in many instruments regulated by the U.S. Commodity Futures Trading Commission (CFTC) must be confined to CFTC-regulated "contract markets." However, swap agreements that meet the CFTC's exemption standards or its policy statements regarding swaps may be offered and entered into without using a designated contract market. While the exemption standards are not free from ambiguity as they apply to online exchanges such as ours, we believe that our swap program complies with these standards. In particular, we believe that the participants on our exchange meet the criteria of "eligible swap participants" as defined by the CFTC. Further, after matching offered terms on our exchange, participants must enter into bilateral swap agreements offline in order to create legally binding swap transactions. Moreover, we believe that our program to facilitate swap transactions conforms with the CFTC's swaps policy statement. While we have obtained the advice of counsel regarding these issues, we have not obtained a written opinion of counsel nor have we sought one. Any written opinion would not be binding on either the CFTC or any party to a swap transaction and would have to reflect the ambiguity in current regulations as applied to online exchanges such as ours. Accordingly, we believe a written opinion of counsel would be of limited utility. If the CFTC or a member of our exchange were to take the position that the swap agreements entered into by members on our exchange are required to be entered into using a designated contract market and if that position were sustained by a court having jurisdiction over us or our members, we could not continue to offer a swap program, and the swap agreements previously entered into could be unenforceable, possibly resulting in claims against us and the counterparties to those transactions. Furthermore, the CFTC might seek fines and penalties against us. The mere threat of such a challenge by the CFTC might cause us to cease facilitating the trading of swap agreements. Furthermore, if the CFTC were to take other adverse actions, such as effecting a change in CFTC rules or policies that would prohibit us from facilitating swap transactions, or if Congress were to amend the Commodity Exchange Act in an adverse manner, our ability to offer a swap program could be impaired or foreclosed. The occurrence of any of these events would adversely affect our business, results of operations and financial condition. WE COULD INCUR LIABILITY AS A RESULT OF OUR ARRANGING FOR THE TRANSPORTATION OF PRODUCTS PURCHASED AND SOLD ON OUR TRADING EXCHANGE. As an additional service for our members, we plan in the future to assist in arranging for the transportation of the commodity chemicals, plastics and other products purchased and sold on our trading exchange. While we will not take title to these products, we intend to provide one or more hyperlinks from our trading exchange web site to web sites operated by one or more transporters of products purchased and sold on our trading exchange. We believe our contractual arrangements with these transporters provide us with full indemnification against any claims made against us. By arranging for transportation of these products, however, we could become subject to claims for environmental cleanup costs, property damages or personal injuries in connection with a release or spill of these products while they are in transit. Any such claim may result in considerable expense to us and divert our management's attention from our business and, in the event that our contractual rights are not upheld in court, may subject us to significant liability. WE MAY BECOME SUBJECT TO LIABILITY FOR INFORMATION DISPLAYED ON OUR WEB SITES THAT REQUIRES US TO DEFEND AGAINST LEGAL CLAIMS. An array of information resources are available on our web sites to our exchange members and users of our information resources. We may be subject to claims for defamation, libel, copyright or trademark infringement or based on other theories relating to the information we publish on our web sites. These types of claims have been brought, sometimes successfully, against online services as well as other print publications in the past. We could also be subject to claims based upon the content that is accessible from our web sites through links to other web sites. Our insurance may not adequately protect us against these claims. Any costs incurred as a result of these claims could negatively affect our business, revenues, results of operations and financial condition. WE MAY INCUR SIGNIFICANT COSTS TO DEFEND OR ESTABLISH OUR INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS. We cannot guarantee that the steps we have taken or will take to protect our proprietary rights will be adequate to deter misappropriation of our intellectual property. In addition, we may not be able to detect unauthorized use of our intellectual property and take appropriate steps to enforce our rights. If third parties infringe or misappropriate our trade secrets, copyrights, trademarks or other proprietary information, our business could be seriously harmed. In addition, although we believe that our proprietary rights do not infringe the intellectual property rights of others, other parties may assert infringement claims against us or claim that we have violated their intellectual property rights. Infringement claims, even if not true, could result in significant legal and other costs and may be a distraction to management. In addition, protection of intellectual property in many foreign countries is weaker and less reliable than in the United States, so if our business expands into foreign countries, risks associated with protecting our intellectual property will increase. UNDETECTED YEAR 2000 COMPLIANCE ISSUES COULD STILL HARM OUR BUSINESS. Our business may suffer as a result of defects relating to Year 2000 compliance issues that have not yet been detected. The hardware and software systems that are central to our marketplace are vulnerable to interruption from power failures, telecommunications outages, and network service outages. Our trading exchange and information resource center could fail to function properly in the event that third party service providers we rely upon encounter Year 2000 problems. If this happens, it could result in liability to us or adversely affect our business, revenues, results of operations and financial condition. RISKS RELATED TO INTERNET-BASED BUSINESSES OUR SUCCESS DEPENDS ON THE CONTINUED ADOPTION OF THE INTERNET AS A MEANS FOR COMMERCE. Our future success depends heavily on the continued adoption of the Internet as a means for commerce. The widespread acceptance and adoption of the Internet for conducting business is likely only in the event that the Internet provides businesses with greater efficiencies and other advantages. If commerce on the Internet does not continue to grow, or grows more slowly than expected, our growth would decline and our business would be seriously harmed. Businesses may reject the Internet as a viable commercial medium for a number of reasons, including: - potentially inadequate network infrastructure; - delay in the development of Internet enabling technologies and performance improvements; - delay in the development or adoption of new standards and protocols required to handle increased levels of Internet activity; - delay in the development of security and authentication technology necessary to effect secure transmission of confidential information; - change in, or insufficient availability of, telecommunications services to support the Internet; and - failure of companies to meet their customers' expectations in delivering goods and services over the Internet. INCREASING GOVERNMENT REGULATION COULD AFFECT OUR BUSINESS. We are subject to laws and regulations directly applicable to general business as well as e-commerce. State, federal and foreign governments may adopt new and cumbersome laws and regulations relating to e-commerce. Any such legislation or regulation could dampen the growth of the Internet and decrease its acceptance as a communications and commercial medium. If such a decline occurs, companies may decide in the future not to use our services as an electronic business channel. This decrease in the demand for our services would seriously harm our business and operating results. Any new laws and regulations may govern or restrict any of the following issues: - user privacy; - the pricing and taxation of goods and services offered over the Internet; - the content of web sites; - consumer protection; and - the characteristics and quality of products and services offered over the Internet. SECURITY RISKS AND CONCERNS MAY DETER THE USE OF THE INTERNET FOR CONDUCTING COMMERCE. Concern about the security of the transmission of confidential information over public networks is a significant barrier to e-commerce and communication. Advances in computer capabilities, new discoveries in the field of cryptography or other events or developments could result in compromises or breaches of Internet security systems that protect proprietary information. If any well-publicized compromises of security were to occur, they could substantially reduce the use of the Internet for commerce and communications. Anyone who circumvents our security measures could misappropriate proprietary information or cause interruptions in our services or operations. Our activities involve the storage and transmission of proprietary information, such as confidential buyer and supplier information. The Internet is a public network, and data is sent over this network from many sources. In the past, computer viruses have been distributed and have rapidly spread over the Internet. Computer viruses could be introduced into our systems or those of our members, which could disrupt our trading exchange technology or make it inaccessible to our members. We may be required to expend significant capital and other resources to protect against the threat of, or to alleviate problems caused by, security breaches and the introduction of computer viruses. Our security measures may be inadequate to prevent security breaches or combat the introduction of computer viruses, either of which may result in loss of data, increased operating costs, litigation and possible liability. RISKS RELATED TO THIS OFFERING AND THE SECURITIES MARKETS OUR STOCK WILL LIKELY BE SUBJECT TO SUBSTANTIAL PRICE AND VOLUME FLUCTUATIONS THAT MAY PREVENT YOU FROM RESELLING YOUR SHARES AT A PROFIT. The securities markets have experienced significant price and volume fluctuations, and the market prices of the securities of technology and Internet companies have been especially volatile. This market volatility, as well as general economic, market or political conditions, could reduce the market price of our common stock in spite of our operating performance. The market price of our common stock after this offering may vary significantly from the initial offering price in response to any of the following factors, some of which are beyond our control: - changes in financial estimates or investment recommendations by securities analysts relating to our stock; - changes in market valuations of other e-commerce marketplaces, software and service providers or other electronic businesses; - announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments; - loss of significant members; - additions or departures of key personnel; and - fluctuations in the stock market price and volume of traded shares generally, especially fluctuations in the traditionally volatile technology and Internet sectors. Investors may be unable to resell their shares of our common stock at or above the offering price. In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of management's attention and resources. WE HAVE BROAD DISCRETION IN HOW WE USE THE PROCEEDS OF THIS OFFERING, AND WE MAY NOT USE THE PROCEEDS EFFECTIVELY. Our management could spend the proceeds from this offering in ways with which our stockholders may not agree. Our primary purpose in conducting this offering is to create a public market for our common stock. As of the date of this prospectus, we plan to use the proceeds from this offering for working capital and other corporate purposes as described under "Use of Proceeds" elsewhere in this prospectus. We may also use the proceeds in future strategic acquisitions but do not at present have any acquisitions planned. Until we need to use the proceeds of this offering, we plan to invest the net proceeds in short-term, investment grade, interest-bearing securities. We cannot predict that the proceeds from this offering will be invested to yield a favorable return. OUR OFFICERS AND DIRECTORS AND AFFILIATED PERSONS INFLUENCE OUR BUSINESS AND HOLD A SUBSTANTIAL PORTION OF OUR STOCK AND COULD REJECT MERGERS OR OTHER BUSINESS COMBINATIONS THAT YOU MAY BELIEVE ARE DESIRABLE. We anticipate that our executive officers, directors and individuals or entities affiliated with our executive officers and directors will beneficially own approximately 52% of our outstanding common stock as a group following the consummation of this offering. Acting together, these stockholders would be able to significantly influence matters that our stockholders vote upon, including the election of directors and mergers or other business combinations. WE MAY NEED TO RAISE ADDITIONAL CAPITAL, WHICH MAY NOT BE AVAILABLE. We expect our existing cash balances to be sufficient to meet our working capital and capital expenditure needs excluding acquisitions through the first quarter of 2001. We expect that the net proceeds from this offering and our existing cash balances will be sufficient to meet our working capital and capital expenditure needs excluding acquisitions for approximately two years. In the future, we may need to raise additional funds, and we cannot be certain that we will be able to obtain additional financing on favorable terms or at all. If we need additional capital and cannot raise it on acceptable terms, we may not be able to: - open new offices; - create additional market-specific business units; - enhance our infrastructure and leveragable assets; - hire, train and retain employees; - respond to competitive pressures or unanticipated requirements; or - pursue acquisition opportunities. Our failure to do any of these things could seriously harm our financial condition. Further, any additional capital raised through the sale of equity may dilute your ownership percentage in us. WE HAVE VARIOUS MECHANISMS IN PLACE TO DISCOURAGE TAKEOVER ATTEMPTS, WHICH MAY REDUCE OR ELIMINATE YOUR ABILITY TO SELL YOUR SHARES FOR A PREMIUM IN A CHANGE OF CONTROL TRANSACTION. Various provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a change in control of CheMatch that a stockholder may consider favorable. These provisions include: - authorizing the issuance of "blank check" preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt; - prohibiting cumulative voting in the election of directors, which would otherwise allow less than a majority of stockholders to elect director candidates; - requiring super-majority voting to effect certain amendments to our certificate of incorporation and bylaws; - limiting who may call special meetings of stockholders; - prohibiting stockholder action by written consent, which requires all actions to be taken at a meeting of the stockholders; and - establishing advance notice requirements for nominations of candidates for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings. SECTION 203 OF THE DELAWARE GENERAL CORPORATION LAW MAY INHIBIT POTENTIAL ACQUISITION BIDS. Section 203 of the Delaware General Corporation Law may inhibit potential acquisition bids for our company. Upon completion of this offering, we will be subject to the antitakeover provisions of the Delaware General Corporation Law, which regulate corporate acquisitions. Delaware law will prevent us from engaging, under certain circumstances, in a "business combination" with any "interested stockholder" for three years following the date that the interested stockholder became an interested stockholder unless our board of directors or a supermajority of our uninterested stockholders agree. For purposes of Delaware law, a "business combination" includes a merger or consolidation involving us and the interested stockholder and the sale of more than 10% of our assets. In general, Delaware law defines an "interested stockholder" as any holder beneficially owning 15% or more of the outstanding voting stock of a corporation and any entity or person affiliated with or controlling or controlled by the holder. Under Delaware law, a corporation may opt out of the foregoing antitakeover provisions. We do not intend to opt out of the antitakeover provisions of Delaware Law. PURCHASERS IN THIS OFFERING WILL INCUR IMMEDIATE AND SUBSTANTIAL DILUTION. The initial public offering price of our common stock will be substantially higher than the book value per share of our outstanding common stock. As a result, if we were liquidated for book value immediately following this offering, each stockholder purchasing in this offering would receive less than the price they paid for their common stock. FUTURE SALES OF OUR COMMON STOCK COULD CAUSE OUR STOCK PRICE TO DECLINE. After this offering is completed, 21,593,195 shares of our common stock will be issued and outstanding, assuming no exercise of the underwriters' over-allotment option and assuming no granting or exercise of warrants or options after June 30, 2000. All of the shares of our common stock sold in this offering will be freely tradable unless purchased by our "affiliates." In connection with this offering, our officers, directors and stockholders not purchasing in the offering who together own approximately 16,349,295 shares of our common stock agreed to refrain from selling any shares of our common stock for a period of 180 days after the date of this prospectus. 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 will be 21,593,195 shares outstanding upon the completion of this offering, of which 18,849,499 shares will become available for sale to the public 180 days from the date of this prospectus, subject in some cases to volume limitations. The preceding sentences assume that the early release provisions of applicable lock-up agreements do not apply.

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+RISK FACTORS You should carefully consider the risks described below before making an investment decision. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations. Our business, financial condition or results of operations could be materially adversely affected by any of these risks. The trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment. This prospectus also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including the risks faced by us as described below and elsewhere in this prospectus. RISKS RELATED TO OUR BUSINESS OUR BUSINESS MODEL IS EVOLVING AND WE HAVE A LIMITED OPERATING HISTORY UNDER OUR CURRENT MODEL. Historically, we have engaged in developing customized HR software applications for large employers on a hosted basis, primarily focused on benefits enrollment. These applications were not created with a scalable object-oriented architecture and therefore cannot be effectively hosted for multiple clients. As a result, although a significant portion of our revenues are classified as hosted service revenues, they were generated through a more labor intensive and less leveraged process than that of hosting software applications that require little, if any, customization or enhancement. In conjunction with our recapitalization in February 1999, and facilitated by both our access to capital and the recruitment of our new executive team, we shifted our focus toward providing a wider range of HR self-service applications and designing a platform that incorporates re-usable business objects that can more easily and cost effectively host our solutions. Later in 1999, we purchased assets of the employee self-service business of Edify Corporation, as well as assets of NOAH Software. As a result, we began to license employee and manager self-service solutions for use by clients on-premise and expanded the applications we offer on a hosted basis. Therefore, you should not view our historical financial statements as a basis on which to evaluate our current business or future prospects. In addition, we have a limited operating history under our current management and are still in the process of fully integrating the Edify and NOAH acquisitions. This integration requires significant management resources in order to maintain and transition existing client relationships. If we are not successful in effectively managing this integration and timely deploying our solutions for clients while providing a high level of customer service, our business, financial condition and results of operations would be materially adversely affected. Under our new business model, we plan to change to a pricing model based on the number of employees using our applications or the number of transactions effected through our applications under multi-year contracts. It may become more difficult for us to attract new clients under this pricing model. Moreover, the revenue and income potential of our business and target market are still unproven. Accordingly, you should consider our prospects in light of the risks and difficulties frequently encountered by companies with a limited history of operating in a new and unproven market, especially companies in new, rapidly evolving and highly competitive markets. WE HAVE A HISTORY OF LOSSES AND EXPECT TO INCUR LOSSES IN THE FUTURE. We incurred net losses of $23.0 million in 1999. As of December 31, 1999, we had an accumulated deficit of approximately $23.0 million. We expect to derive substantially all of our revenues for the foreseeable future from our HR self-service solutions. We may not be successful in generating any revenue growth, and our revenues could decline. Moreover, we expect to incur significant sales and marketing, research and development, and general and administrative expenses and make significant capital expenditures as we continue to expand our operations. As a result, we expect to incur significant losses and negative cash flow for the foreseeable future. OUR BUSINESS WILL SUFFER IF OUR TARGET CLIENTS DO NOT ADOPT OUR SOLUTIONS. The market for HR self-service solutions is at an early stage of development. Our ability to increase revenues and achieve profitability depends on the adoption and acceptance of HR self-service applications by our target market of large employers. The market for these services has only recently begun to develop and is evolving rapidly. In addition, companies that have already invested substantial resources in other methods of automating enterprise processes may be reluctant to adopt a new strategy that may limit or compete with their existing investments. If our target clients do not adopt and accept our solutions, or if we do not timely deploy solutions for our clients or fail to provide a high level of customer service, our business, financial condition and results of operations would be materially adversely affected. THE HR SELF-SERVICE SOLUTIONS INDUSTRY IS COMPETITIVE AND WE FACE COMPETITION FROM MANY PARTICIPANTS. The market for our HR self-service solutions is intensely competitive, evolving and subject to rapid technological change. We expect the intensity of competition to increase in the future. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any one of which could seriously harm our business. Competitors vary in size and in the scope and breadth of the products and services offered. We primarily encounter competition with respect to different aspects of our product offerings from Concur Technologies, Decisis, iClick, Interlynx, iTango, Kronos, ProBusiness, TALX and other benefits administrators and consultants. We also encounter competition from major enterprise software developers such as PeopleSoft and SAP. We believe the biggest near-term competitive threat is that these vendors will actively promote enhanced Web capabilities, which may, at a minimum, delay clients' purchasing decisions. We expect additional competition from other established and emerging companies as the HR self-service software market continues to develop and expand. Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed client base than we do. In addition, many of our competitors have well-established relationships with our current and potential clients and have extensive knowledge of our industry. In the past, we have lost potential clients to competitors for a variety of reasons, including lower prices and other incentives not matched by us. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address client needs. Accordingly, new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We also expect that competition will increase as a result of industry consolidations. We may not be able to compete successfully against our current and future competitors. OTHERS MAY SEIZE THE MARKET OPPORTUNITIES WE HAVE IDENTIFIED BECAUSE WE MAY NOT EFFECTIVELY EXECUTE OUR STRATEGY. If we fail to execute our strategy in a timely or effective manner, our competitors may be able to seize the market opportunities we have identified. Our business strategy requires that we successfully and simultaneously complete many tasks. In order to be successful, we will need to: o attract more clients and retain existing clients; o deploy our new platform currently under development; o transition existing clients who currently license our on-premise software applications to a hosted solution; o respond effectively to competitive pressures; o continue to upgrade and enhance our existing technology; o attract, integrate, retain and motivate qualified personnel; and o successfully integrate acquired companies, if any, into our operations. We may not be able to successfully execute all elements of our strategy. FAILURE TO LAUNCH OUR NEW PLATFORM COULD ADVERSELY AFFECT OUR STOCK PRICE. Our growth plans assume the success of a new platform that we are currently developing. This new platform will be a key technological element to increasing the number and performance of the products we offer to our clients. There are significant risks inherent in introducing a new platform. We may not be able to achieve the growth or profitability we have planned if (1) we are not able to deploy this new platform on the schedule we have established without significant problems or disruption in service to our clients, (2) we experience significant overruns in the costs we have budgeted for deployment of the new platform or (3) our platform does not achieve market acceptance. As a result, our stock price could be materially adversely affected. In addition, existing clients who have expended the time and money to implement premise-based solutions which run on the Electronic Workforce platform we currently license from S-1 Corporation (which acquired Edify Corporation subsequent to our acquisition of assets of Edify's employee self-service business) may not recognize the advantages of our new platform. As a result, we may need to maintain two platforms in order to support both existing and new clients. OUR FAILURE TO MEET CLIENT EXPECTATIONS OR DELIVER ERROR-FREE SERVICES COULD RESULT IN LOSSES AND NEGATIVE PUBLICITY. Many of our applications involve information technology solutions that are critical to the relationship between our clients and their employees. Our clients rely on our ability to deliver reliable technology according to the agreed budget and timetable for implementation of the solution. Any defects or errors in these solutions or our failure to meet clients' specifications or expectations could result in: o delayed or lost revenues due to adverse client reaction; o requirements to provide additional services to a client at no charge; o refunds of fees for failure to meet service level obligations; o negative publicity about us and our services, which could adversely affect our ability to attract or retain clients; and o claims for substantial damages against us, regardless of our responsibility for such failure, which may not be covered by our insurance policies and which may not be limited by the contractual terms of our engagement. In particular, if we do not meet client deadlines in deploying solutions or do not provide high-quality customer service and support, clients may terminate their arrangements with us, and we will lose the opportunity to sell additional solutions to these clients in the future. OUR HOSTED SOLUTIONS DEPEND ON THE STABILITY AND INTEGRITY OF OUR COMPUTER NETWORK AND TELEPHONE OPERATIONS. Significant portions of our operations depend on our ability to protect our computer equipment and the information stored in our data processing center against damage that may be caused by fire, power loss, telecommunications failures, unauthorized intrusion and other events. Software and related data files are backed-up regularly and stored off-site. These measures may not be sufficient to eliminate the risk of extended interruption in our operations. In addition, clients will depend on Internet service providers, telecommunications companies and the efficient operation of their computer networks and other computer equipment for access to our hosted solutions. Each of these has experienced significant outages in the past and could experience outages, delays and other difficulties due to system failures unrelated to our systems. Any damage to our systems or any third-party system failure that interrupts our operations could have a material adverse effect on our business, financial condition and results of operations. WE DEPEND ON SOFTWARE LICENSED FROM OTHERS FOR OUR CURRENT PRODUCTS. We must now, and may in the future need to, license or otherwise obtain access to intellectual property of third parties. For example, our on-premise HR self-service applications depend on the Electronic Workforce platform we license from S-1 Corporation. The license for the underlying Electronic Workforce platform expires in July 2001. We are entitled to a copy of the source code for that platform if S-1 Corporation is not then supporting the platform, but only for use in supporting our existing clients that license our on-premise solutions. We may not be able to obtain this or any other required third party intellectual property in the future. If we are unable to commercially deploy our new platform prior to expiration of the license from S-1 Corporation and are unable to renew the license from S-1 Corporation, our business, results of operations and financial condition would be materially adversely affected. WE WILL RELY ON A THIRD PARTY TO MANAGE AND MAINTAIN THE HARDWARE NECESSARY FOR THE DAY-TO-DAY OPERATION OF OUR DATA CENTER. We have entered into a contract with Exodus Communications, Inc. to manage and maintain the computer and communications equipment needed for the day-to-day operations of our production data center. The services provided by Exodus will include managing our network server, maintaining communication lines and managing network data centers and the backup and storage of data tapes. Historically, we managed and maintained these services and systems internally. We cannot assure you that Exodus will successfully manage our data center operations on a timely and cost-effective basis. Our operations depend on Exodus' ability to protect its own systems and our systems against damage from fire, power loss, water, telecommunications failures, vandalism and other malicious acts, and similar unexpected adverse events. Any disruption of service or loss of stored data due to the fault of Exodus, over whom we have no control, could have a material adverse effect on our business, financial condition and results of operations. THE PLANNED MOVE OF OUR DATA CENTER MAY INTERRUPT SERVICES TO OUR CLIENTS. We plan to transfer our data hosting facility to new facilities in Framingham, Massachusetts in the second quarter of 2000, and following the transition of our production data center operations to Exodus, to use this new facility for product development testing and staging with the ability to function as a backup data center. Although we have provided for alternate, as well as redundant, hosting capacity during this transition, damage to our equipment, disruption of service or the loss of client data could materially adversely affect our client relationships and could have a material adverse effect on our business, financial condition and results of operations. WE MUST SAFEGUARD THE ACCURACY OF HIGHLY CONFIDENTIAL INFORMATION REGARDING EMPLOYEES PROVIDED TO US BY EMPLOYERS. The effectiveness of our solutions depend on safeguarding the accuracy of highly confidential information regarding an employee's employment and salary history provided to us by employers for use as part of our HR self-service applications. Although we have certain protective measures in place, our failure to maintain the accuracy and confidentiality of such information, whether due to the unauthorized access to information or otherwise, may give rise to potential claims against us and adversely affect market acceptance of our solutions. If any claims should be asserted which are ultimately decided adversely to us, our business, financial condition and results of operations may be materially adversely affected. WE MAY NOT BE ABLE TO SUCCESSFULLY LAUNCH NEW PRODUCTS. Our future financial performance will depend upon the successful development, introduction and market acceptance of new and enhanced versions of our HR self-service products. We may not be successful in upgrading or marketing our HR self-service products, and any new products we may develop or acquire may not achieve market acceptance. New products may not be released according to schedule, or when released may contain defects. If we are unable to develop, license or acquire new software products or enhancements to existing products on a timely and cost-effective basis, or if our new products or enhancements do not achieve market acceptance, our business, results of operations and financial condition may be materially adversely affected. OUR SUCCESS DEPENDS ON RETAINING OUR CURRENT KEY PERSONNEL AND ATTRACTING ADDITIONAL KEY PERSONNEL, PARTICULARLY IN THE AREAS OF DIRECT SALES AND RESEARCH AND DEVELOPMENT. Our future performance depends on the continued service of our senior management, particularly James Carlson, our Chief Executive Officer, Timothy Clifford, our President and Chief Operating Officer, and Lee Ingram, our Chief Technology Officer. The loss of the services of one or more of our key personnel could seriously harm our business. Our future success also depends on our continuing ability to attract, hire, train and retain a substantial number of highly skilled managerial, technical, sales, marketing and client support personnel. We are particularly focused on hiring additional personnel to increase our direct sales and research and development staff, many of whom may require extensive training before they achieve desired levels of productivity. Competition for qualified personnel, particularly technical personnel, is intense, and we may fail to retain our key employees or to attract or retain other highly qualified personnel. IN ORDER TO MANAGE OUR GROWTH AND EXPANSION, WE WILL NEED TO IMPROVE AND IMPLEMENT OUR MANAGEMENT AND OPERATIONAL SYSTEMS AND INTERNAL CONTROLS ON A TIMELY BASIS. We have expanded our operations rapidly. We are currently working to complete the integration of businesses we acquired during 1999. As we have grown our business, our number of employees has also grown very rapidly and we are working to integrate our workforce and build and maintain a high-quality product implementation and client services team to meet client expectations. We intend to continue to expand in the foreseeable future to pursue existing and potential market opportunities. This rapid growth places a significant demand on management and operational resources. To be successful, we will need to implement additional management information systems, improve our operating, administrative, financial and accounting systems, procedures and controls, train new employees and maintain close coordination among our executive, engineering, professional services, accounting, finance, sales and marketing organizations. Unless we are able to put into place effective and efficient internal controls and accounting procedures and further develop our corporate, legal and accounting infrastructure, we may not be able to accurately assess the operating and financial condition of our business on a timely basis or to plan for future growth. This may have a negative impact on our business and results of operations. We will have to make a significant investment in facilities and networks next year to manage our forecasted growth in providing hosted solutions. If the volume of traffic from hosted solutions increases, our customers may in the future experience slower response times or other problems. Any delays in response time or performance problems could cause users of our hosted solutions to perceive our solutions as not functioning properly. If we are unable to expand or outsource our data center operations to meet this projected increase in volume, our business, results of operations and financial condition could be materially adversely affected. IF WE FAIL TO RESPOND TO RAPID TECHNOLOGICAL CHANGE AND EVOLVING INDUSTRY STANDARDS, OUR PRODUCTS MAY BECOME OBSOLETE. The market for our products is characterized by rapid technological change, evolving industry standards in computer hardware and software technology, changes in client requirements and frequent new product introductions and enhancements. The introduction of products embodying new technologies and the emergence of new industry standards can render existing products obsolete and unmarketable. As a result, our future success will depend, in significant part, upon our ability to develop and introduce new products and to enhance existing products to keep pace with technological developments, satisfy client requirements and achieve market acceptance. We may not successfully identify new product opportunities, develop or bring to market new products, or adopt or incorporate new technologies in a timely and cost-effective manner. Products, capabilities or technologies developed by others may render our products or technologies obsolete or noncompetitive or shorten the life cycles of our products. IF THE PROTECTION OF OUR INTELLECTUAL PROPERTY IS INADEQUATE, OUR COMPETITORS MAY GAIN ACCESS TO OUR TECHNOLOGY, AND WE MAY LOSE CLIENTS. We depend on our ability to develop and maintain the proprietary aspects of our technology. To protect our proprietary technology, we rely primarily on a combination of contractual provisions, confidentiality procedures, trade secrets and copyright and trademark laws. When we license our on-premise software, we require our clients to enter into license agreements, which impose restrictions on their ability to utilize the software. In addition, we seek to avoid disclosure of our trade secrets through a number of means, including requiring people with access to our proprietary information to execute confidentiality agreements with us and restricting access to our source codes. We seek to protect our software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult, and while we are unable to determine the extent to which unauthorized use of our software products exists, software piracy can be expected to be a persistent problem. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Our means of protecting our proprietary rights may not be adequate and our competitors may independently develop similar technology or duplicate our products. We have no patents. We may not develop proprietary products or technologies that are patentable. Future patents, if any, may be successfully challenged or may not provide us with any competitive advantages. Our proprietary rights with respect to our solutions may not be viable or of value in the future because the validity, enforceability and type of protection of proprietary rights are uncertain and still evolving. There has been a substantial amount of litigation in the software industry and the Internet industry regarding intellectual property rights. There is also uncertainty regarding the applicability of existing laws to the Internet regarding matters such as property ownership, copyrights and other intellectual property rights. Most of these laws were adopted prior to the advent of the Internet and, as a result, do not contemplate or address the unique issues applicable to the Internet and related technologies. It is possible that in the future, third parties may claim that we or our current or potential future products infringe upon their intellectual property. We expect that software product developers and providers of HR self-service solutions will increasingly be subject to infringement claims as the number of products and competitors in our industry grows and the functionality of products in different industries overlaps. Any claims, with or without merit, could be time-consuming, result in costly litigation, cause product deployment delays or require us to enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could seriously harm our business. WE RELY ON THIRD-PARTY CONTRACTORS TO DO A SIGNIFICANT PORTION OF OUR RESEARCH AND DEVELOPMENT. We contract with third parties to provide a significant portion of our research and development. In addition, our business plan calls for increased use of third-party research and development personnel in the future. With the recent rapid growth in Internet-based applications, qualified software developers and programmers are in increasing demand. We may not be able to perform the amount of research and development required to grow our business as planned if we are unable to contract with quality, third-party software developers upon commercially reasonable terms. OUR QUARTERLY OPERATING RESULTS ARE SEASONAL AND MAY VARY BASED ON OTHER FACTORS. IF WE FAIL TO MEET THE EXPECTATIONS OF ANALYSTS OR INVESTORS, THE MARKET PRICE OF OUR COMMON STOCK MAY DECREASE SIGNIFICANTLY. Historically, our quarterly operating results have been related to seasonal HR events such as annual benefits enrollments, and may continue to be seasonal in the future. Employers generally have "open enrollment" benefit periods in the fall, and as a result, the majority of our services are provided in the third and fourth quarters of the year. Accordingly, our quarterly operating results may fluctuate significantly if revenues related to seasonal benefits enrollment continue to represent a majority of our revenues or if we experience changes in the purchasing patterns of significant clients. We believe that period-to-period comparisons of our results of operations should not be relied upon as indicators of future performance. Our operating results will likely fall below the expectations of securities analysts or investors in some future quarter or quarters. Our failure to meet these expectations would likely adversely affect the market price of our common stock. Our quarterly operating results may vary depending on a number of factors, including: o demand for our HR self-service solutions; o actions taken by our competitors, including new product introductions and enhancements; o our ability to scale our operations to support a large number of clients and functions; o our ability to develop, introduce and market new products and enhancements to our existing products on a timely basis; o changes in our pricing policies or those of our competitors; o our ability to expand our sales and marketing operations, including hiring additional sales personnel; o the effect of acquisitions; o changes in our pricing model and sales mix; o changes in our revenue recognition policies; o purchasing patterns of our clients; o size and timing of sales of our products; o success in maintaining and enhancing existing relationships and developing new relationships with strategic partners, including marketing and implementation partners; o our ability to control costs; o technological changes in our markets; o deferrals of client orders in anticipation of product enhancements or new products; o client budget cycles and changes in these budget cycles; and o general economic factors. We plan to increase our operating expenses to expand our sales and marketing operations, fund greater levels of research and development, develop strategic alliances, increase our professional services and support capabilities and improve our operational and financial systems. If our revenues do not increase along with these expenses, our business, operating results and financial condition could be seriously harmed and net losses in a given quarter could be larger than expected. THE SUCCESSFUL DEVELOPMENT AND LAUNCH OF OUR EMPLOYEE.COM PORTAL WILL AFFECT OUR ABILITY TO MEET OUR PLANS FOR GROWTH. An important element of our business strategy is to develop and introduce Employee.com, a worksite portal for eCommerce transactions. We have no experience promoting the sale of products or services through an eCommerce portal site and the revenue model we envision for Employee.com will differ from the pricing model used for our on-premise and hosted solutions. Our efforts to develop this portal may divert management time and attention and may require substantial investment. We may not be able to develop and launch Employee.com on a timely basis, if at all. At this time, we have not begun actual development of this portal, nor have we begun sales activity to attract clients. We do not yet have any agreements with vendors to offer products and services through this portal. Our ability to develop Employee.com will depend entirely on the success of our planned transition to a new platform. The new platform may not be released according to schedule, or may not meet client needs or expectations or be free of defects. In addition, ongoing developments in consumer privacy protection laws may limit our ability to capitalize on our permission-based access to employee-specific data for our Employee.com portal. Furthermore, our target market of large employers may not recognize the benefits of our Employee.com portal and this concept may not be readily adopted and accepted. Any problems associated with the development, launch and marketing of Employee.com would affect our ability to meet our plans for growth and would cause our stock price to decline. WE RELY ON A SMALL NUMBER OF CLIENTS FOR A SIGNIFICANT PORTION OF OUR REVENUES; OUR REVENUES WILL DECLINE SIGNIFICANTLY IF WE CANNOT KEEP OR REPLACE THESE CLIENTS. In 1999, revenues from a single client accounted for approximately 20% of our total revenues, and revenues from our 10 largest clients accounted for approximately 55% of our total revenues. If these clients do not need or want to continue to purchase our solutions and we are not able to sell our solutions to new clients at comparable or greater levels, our revenues may decline significantly. IN THE FUTURE, WE MAY NEED TO RAISE ADDITIONAL CAPITAL IN ORDER TO REMAIN COMPETITIVE. THIS CAPITAL MAY NOT BE AVAILABLE ON ACCEPTABLE TERMS, IF AT ALL. We expect the net proceeds from this offering, together with cash on hand, will be sufficient to meet our day-to-day working capital and capital expenditure needs for at least the next 12 months. After that, we may need to raise additional funds and we cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. In addition, if we decide to pursue acquisitions for cash consideration, we may need to raise additional capital. If we cannot raise funds on acceptable terms, if and when needed, we may not be able to develop or enhance our products and services, take advantage of future opportunities, grow our business or respond to competitive pressures or unanticipated requirements, each of which could seriously harm our business. WE MAY NEED TO MAKE ACQUISITIONS IN ORDER TO REMAIN COMPETITIVE IN OUR MARKET. OUR BUSINESS COULD BE ADVERSELY AFFECTED AS A RESULT OF ANY FUTURE ACQUISITIONS. A substantial portion of our recent growth has been the result of acquisitions. In order to remain competitive, we may find it necessary to acquire additional businesses, products or technologies. If we identify an appropriate acquisition candidate, we may not be able to negotiate the terms of the acquisition successfully, finance the acquisition, or integrate the acquired business, products or technologies into our existing business and operations. If we consummate one or more significant acquisitions in which the consideration consists of stock or other securities, your equity could be significantly diluted. In addition, we may be required to amortize significant amounts of goodwill and other intangible assets in connection with future acquisitions, which would adversely impact our results of operations. IF WE EXPAND OUR INTERNATIONAL SALES AND MARKETING ACTIVITIES, OUR BUSINESS WILL BE SUSCEPTIBLE TO NUMEROUS RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS. We intend to expand our international operations. Therefore, we expect to commit significant resources to expand our international sales and marketing activities. We will be subject to a number of risks associated with international business activities. These risks generally include: o currency exchange rate fluctuations; o unexpected changes in regulatory requirements; o tariffs, export controls and other trade barriers; o longer accounts receivable payment cycles and difficulties in collections; o difficulties in managing and staffing international operations; o potentially adverse tax consequences, including restrictions on the repatriation of earnings; o the burdens of complying with a wide variety of foreign laws; o the risks related to the recent global economic turbulence and adverse economic circumstances in various countries; and o political instability. RISKS RELATED TO OUR INDUSTRY OUR FUTURE GROWTH DEPENDS ON INCREASING USE OF THE INTERNET AND ON THE GROWTH OF HOSTED SOLUTIONS. IF THE USE OF INTERNET TECHNOLOGY AND HOSTED SOLUTIONS DOES NOT GROW AS ANTICIPATED, OUR BUSINESS WILL BE SERIOUSLY HARMED. Rapid growth in the use of the Internet is a recent phenomenon. As a result, acceptance and use may not continue to develop at historical rates and a sufficiently broad base of our target clients may not adopt or continue to use Internet technology to administer their HR self-service solutions. Demand and market acceptance for recently introduced services and products over the Internet are subject to a high level of uncertainty, and there exist few proven services and products. Our business would be seriously harmed if: o use of the Internet does not continue to increase or increases more slowly than expected; or o the technological infrastructure underlying the Internet does not effectively support any expansion that may occur. SECURITY RISKS AND CONCERNS MAY DETER THE USE OF THE INTERNET FOR HOSTING HR SOLUTIONS AND WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS. A significant barrier to electronic commerce and communications is the secure transmission of confidential information over public networks. Advances in computer capabilities, new discoveries in the field of cryptography or other events or developments could result in compromises or breaches of our security systems or those of other Web sites and the inability to protect proprietary information. If any well-publicized compromises of security were to occur, it could have the effect of substantially reducing the use of the Web for commerce and communications. Anyone who circumvents our security measures could misappropriate proprietary information or cause interruptions in our services or operations. The Internet is a public network, and data is sent over this network from many sources. In the past, computer viruses, software programs that disable or impair computers, have been distributed and have rapidly spread over the Internet. Computer viruses could be introduced into our systems or those of our clients or their employees, which could disrupt our hosting services or make it inaccessible to clients or their employees. We may be required to expend significant capital and other resources to protect against the threat of security breaches or to alleviate problems caused by breaches. To the extent that our activities may involve the storage and transmission of proprietary information, such as credit card numbers, security breaches could expose us to a risk of loss or litigation and possible liability. Our security measures may be inadequate to prevent security breaches, and our business would be harmed if we do not prevent them. Our Internet and corporate Intranet applications may result in unauthorized access and similar disruptive problems caused by Internet or other users. Such unauthorized access and other disruptions could jeopardize the security of information stored in and transmitted through the computer systems of our clients, which may result in significant liability to us and deter potential clients from purchasing our products. Our license agreements with our clients typically contain provisions designed to limit our exposure to potential product liability claims. It is possible, however, that the limitation of liability provisions contained in our license agreements may not be effective under the laws of some jurisdictions. Although we have not experienced any product liability claims to date, the sale and support of our products or services may entail the risk of such claims. While we maintain insurance for product liability risks, our insurance may not be adequate in the event of a material product liability claim. A successful product liability claim in excess of our insured limits brought against us could have a material adverse effect on our business, financial condition and results of operations. WE ARE SUBJECT TO RISKS ASSOCIATED WITH GOVERNMENTAL REGULATION AND LEGAL UNCERTAINTIES. Due to the increasing popularity and use of the Internet, state and federal regulators could adopt laws and regulations which could impose additional burdens on companies that use Internet technologies. The adoption of any additional laws or regulations regarding Internet commerce and communications may decrease the growth of the Internet, which could, in turn, decrease the demand for our product and services and increase our cost of doing business, leading to further losses. Few existing laws or regulations specifically apply to the Internet. However, it is likely that a number of laws and regulations may be adopted in the United States and other countries with respect to the Internet. These laws may relate to areas such as copyright and other intellectual property rights, encryption, use of key escrow data, caching of content by server products, electronic authentication or "digital signatures," personal privacy, advertising, taxation, electronic commerce liability, e-mail, network and information security and the convergence of traditional communication services with Internet communications. Other countries and political organizations may impose or favor more and different regulation than that which has been proposed in the United States, thus furthering the complexity of regulation. The adoption of these laws or regulations, and uncertainties associated with their validity and enforcement, may harm our business. Changes to, or the interpretation of, existing laws governing issues such as property ownership, copyright and other intellectual property issues, taxation, illegal content, retransmission of media and personal privacy and data protection as they relate to the Internet could: o limit the growth of the Internet; o create uncertainty in the marketplace that could reduce demand for our products and services; o increase our cost of doing business; o expose us to significant liabilities associated with content distributed or accessed through our products or services; or o lead to increased product development costs, or otherwise harm our business. RISKS RELATED TO THIS OFFERING WE HAVE NOT DESIGNATED A SPECIFIC USE FOR MOST OF THE PROCEEDS OF THIS OFFERING AND HAVE BROAD DISCRETION OVER THEIR USE. We have not designated any specific uses for the net proceeds to be received by us in this offering, other than the redemption of our Series C preferred stock, cash payments required upon conversion of our Series D preferred stock and repayment of outstanding bank term loans. We intend to use the remaining net proceeds primarily for general corporate purposes, including working capital. A portion of the net proceeds of the offering may also be used to acquire or invest in products, technologies or businesses which broaden or enhance our current product offerings. Currently, there are no binding agreements with respect to any acquisitions, investments or other transactions. We have no specific plans as to the use of the remaining net proceeds from this offering, and our senior management will have broad discretion in the application of the proceeds. Our failure to apply these funds effectively could have a material adverse effect on our business, results of operations and financial condition. OUR STOCK PRICE MAY BE VOLATILE, WHICH COULD RESULT IN SUBSTANTIAL LOSSES FOR INVESTORS PURCHASING SHARES IN THIS OFFERING. Prior to this offering, you could not buy or sell our common stock publicly. An active public market for our common stock may not develop or be sustained after the offering. We cannot predict the extent to which investor interest will lead to the development of an active trading market or how liquid that market might become. We will negotiate and determine the initial public offering price with the representatives of the underwriters based on several factors. This price may vary from the market price of the common stock after the offering. You may be unable to sell your shares of common stock at or above the offering price. The market price of the common stock may fluctuate significantly in response to factors, some of which are beyond our control, such as: o variations in our quarterly operating results; o changes in securities analysts' estimates of our financial performance; o changes in market valuations of similar companies; o announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments; o loss of a major client; o additions or departures of key personnel; and o fluctuations in stock market price and volume, which are particularly common among highly volatile securities of software and Internet-based companies. In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We may in the future be the target of similar litigation. Securities litigation, regardless of the outcome, could result in substantial costs and divert management's attention and resources. OUR STOCK PRICE COULD BE AFFECTED BY SHARES OF OUR COMMON STOCK BECOMING AVAILABLE FOR SALE IN THE FUTURE. Sales of a substantial amount of our common stock in the public market after this offering, or the perception that these sales may occur, could adversely affect the prevailing market price of our common stock. This could also impair our ability to raise additional capital through the sale of additional equity securities. Immediately after the completion of this offering, we will have shares of common stock outstanding, or shares if the underwriters exercise their over-allotment option in full. Of these shares, the shares sold in this offering will be immediately transferable without restriction in the public market, except for shares purchased by any of our affiliates, which will be subject to the limitations of Rule 144 under the Securities Act. The remaining shares are "restricted securities," and will become eligible for sale in the public market at various times after the date of this prospectus, subject to the limitations and other conditions of Rule 144 under the Securities Act. In addition, under the terms of a registration rights agreement, we are obligated under certain circumstances to register outstanding shares of our common stock. In connection with this offering, holders of a substantial number of shares of restricted securities and options to purchase our common stock have agreed not to sell the shares of common stock they now own or acquire upon exercise of their options without the prior written consent of Deutsche Bank Securities Inc. for a period of 180 days from the date of this prospectus. Deutsche Bank Securities Inc. may, however, in its sole discretion and without notice, release all or any portion of the shares from the restrictions in the lock-up agreements. After these agreements expire, these shares will be eligible for sale in the public market. PURCHASERS IN THIS OFFERING WILL INCUR IMMEDIATE AND SUBSTANTIAL DILUTION. The initial public offering price is substantially higher than the tangible book value per share of our outstanding common stock. If you purchase common stock in this offering, the shares you buy will experience an immediate and substantial dilution in tangible book value per share, and the shares of common stock owned by the existing stockholders will experience a material increase in the tangible book value per share. As a result, if we were to distribute our tangible assets to our stockholders immediately following this offering, purchasers of shares of common stock in this offering would receive less than the amount paid for such shares. In the past, we issued options and warrants to acquire common stock at prices significantly below the initial public offering price. To the extent these outstanding options or warrants are ultimately exercised, there will be further dilution to investors in this offering. WE HAVE IMPLEMENTED CERTAIN ANTI-TAKEOVER PROVISIONS THAT COULD MAKE IT MORE DIFFICULT FOR A THIRD PARTY TO ACQUIRE US. Provisions of our amended and restated certificate of incorporation and bylaws, as well as provisions of Delaware law, could, together or separately: o discourage potential acquisition proposals; o delay or prevent a change in control; and o limit the price that investors may be willing to pay in the future for shares of our common stock. In particular, our amended and restated certificate of incorporation and bylaws provide, among other things, that our directors be divided into three classes with only one class standing for election at each annual meeting, stockholders may not take actions by written consent, and special meetings of stockholders may only be called by a majority of our board of directors. We are also subject to Section 203 of the Delaware General Corporation Law which generally prohibits a Delaware corporation from engaging in any of a broad range of business combinations with any interested stockholder, as defined in the statute, for a period of three years following the date on which the stockholder became an interested stockholder. These anti-takeover provisions could substantially impede the ability of public stockholders to change our management and board of directors, which may reduce the trading price of our common stock. OUR EXISTING PRINCIPAL STOCKHOLDERS WILL CONTINUE TO CONTROL US AFTER THIS OFFERING AND COULD LIMIT THE ABILITY OF OUR OTHER STOCKHOLDERS TO INFLUENCE THE OUTCOME OF DIRECTOR ELECTIONS AND OTHER TRANSACTIONS SUBMITTED FOR A VOTE OF OUR STOCKHOLDERS AND COULD DEPRESS OUR STOCK PRICE BECAUSE PURCHASERS CANNOT ACQUIRE A CONTROLLING INTEREST. Upon completion of this offering, our existing principal stockholders will beneficially own, in the aggregate, approximately % of our outstanding common stock. As a result, these persons, acting together, will be able to control all matters submitted to our stockholders for approval and to control our management and affairs. For example, these persons, acting together, will control the election and removal of directors and any merger, consolidation or sale of all or substantially all of our assets. Furthermore, as long as affiliates of Warburg, Pincus Equity Partners, L.P. maintain a specified percentage ownership of our stock, the terms of our stockholders agreement require us to nominate persons designated by Warburg Pincus for election to our board. This control could have the effect of delaying or preventing a change of control of our company that stockholders may believe would result in better management. This control could depress our stock price because purchasers will not be able to publicly acquire a controlling interest in our company.

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+RISK FACTORS You should carefully consider the following risks in addition to other information in this prospectus before purchasing our common stock. Risks Related To Our Business We have a history of losses, and we anticipate our losses will continue. We have incurred significant losses since inception, and we expect to continue to incur significant losses for the foreseeable future. We reported net losses applicable to common stockholders of approximately $15.8 million for the six months ended March 31, 2000, $4.1 million for the year ended September 30, 1999, and $722,000 for the period from our inception to September 30, 1998. As a percentage of revenues, our net loss was 272% for the six months ended March 31, 2000, 177% for the year ended September 30, 1999, and 731% for the period from our inception to September 30, 1998. As of March 31, 2000, our accumulated deficit was approximately $20.6 million. Our revenues may not continue to grow or even continue at their current level. In addition, we expect our operating expenses and capital expenditures to increase significantly as we develop and expand our business, especially our offering of business long distance and enhanced communications services. As a result, we will need to increase our revenues significantly to become profitable. In order to augment our revenues, we need to attract additional users to increase the fees we collect for our services. If our revenues do not grow as much as we expect or if our expenses increase at a greater pace than our revenues, we may never be profitable, or if we become profitable, we may not be able to sustain or increase profitability on a quarterly or annual basis. Furthermore, we will have to recognize significant charges relating to non-cash compensation in connection with options that we have granted through March 31, 2000. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Because we have a limited operating history upon which you can evaluate us, it is difficult to predict whether we will successfully develop new businesses, build revenues, and compete effectively. We have only a limited operating history upon which you can evaluate our business and prospects. We commenced operations on October 14, 1997. You should consider our prospects in light of the risks, expenses, and difficulties we may encounter as an early-stage company in the new and rapidly evolving market for IP communications services. The risks include our ability to: . increase the number of users of our Internet telephone services; . develop our business long distance and enhanced communications services; . build revenues to cover the increased marketing expenditures we have planned; . compete effectively; . increase awareness of our brand and build user loyalty; and . keep pace with developing technology. In addition, because we expect an increasing percentage of our revenues to be derived from our business long distance and enhanced communications services, our past operating results may not be indicative of our future results. We may not be able to expand our revenues and achieve profitability. Our strategy is to expand our revenue sources beyond our consumer long distance services to the sale of wholesale carrier transmission services and business long distance and enhanced communications services. This pursuit has required and will continue to require us to make significant additions to our sales and marketing and technology teams. The large investment in capital and other resources required to create these new revenue streams will result in significant losses for the foreseeable future, and we cannot assure you that we will be able to expand our revenue sources or that this strategy will be profitable. Currently our revenues are generated primarily from the sale of consumer long distance services. These services generated 100% of our total revenues in each of the period from inception to September 30, 1998, the year ended September 30, 1999, and the three months ended December 31, 1999. January 2000 was the first month in which we generated any revenues from wholesale carrier transmission services. Providing consumer long distance services and wholesale carrier transmission services has not been profitable to date. In the future, we intend to generate increased revenues from multiple sources, many of which are unproven, including the commercial sale of business long distance and enhanced communications services. We expect that our revenues for the foreseeable future will be dependent on: . our continued sale of wholesale carrier transmission services; . our ability to develop, launch, and rollout business long distance and enhanced communications services successfully; . user traffic levels; . continued rapid growth of the Internet consumer market; . continued improvement of the quality of our global network; . our ability to counteract the effects of competition, adverse regulatory developments, decreasing international long distance rates, and rising access and transmission costs on our prices; . the acceptance and use of Internet communications; and . the expansion of our service offerings. We may not be able to sustain our current revenues from the sale of consumer long distance services and wholesale carrier transmission services or to generate revenues successfully from business long distance and enhanced communications services in the future. We have not yet developed our CommPortal product, and if we do not succeed in being able to develop, launch, and rollout this product in a timely manner, our business, operations, and potential for profitability will be severely harmed. To improve our margins over the long run, we must capture the corporate market for enhanced IP services in Asia and develop our integrated Internet- based suite of communications services for corporate customers. We are therefore in the process of developing a product that would offer corporate customers a variety of enhanced IP services including instant messaging, PC- based voice and text chat, conferencing services over the Internet, and unified messaging. We are, however, still in the initial stages of the development of CommPortal. We must enter into agreements with technology providers to sell or license the technologies that will comprise CommPortal. We cannot assure you that we will be able to enter into these agreements on commercially reasonable terms. In addition, even after we have identified and licensed or acquired the applications, we will need to combine these applications into one integrated solution and add security measures, such as firewalls. We cannot assure you that we will be able to create an integrated and secure solution in time to rollout CommPortal as planned or that we will ever be able to offer CommPortal. If CommPortal is delayed, our business and financial condition will be materially adversely affected and our reputation may be harmed. If we are unable to offer CommPortal, we will not be able to expand our business, and our financial condition and results of operations will be severely harmed. Potential fluctuations in our quarterly financial results could make it difficult for investors to predict our future performance, which may cause our stock price to be volatile and decline. Our quarterly operating results may fluctuate significantly in the future as a result of a variety of factors, many of which are outside our control. The factors generally within our control include: . the resources we employ to attract users to purchase our business long distance and enhanced communications services; . the amount and timing of expenses we incur to enhance marketing and promotion efforts and to expand our infrastructure; and . the timing of announcements or introductions of new services by us. The factors outside our control include: . changes in international or domestic telecommunications rates; . the timing of announcements or introductions of new services by our competitors; . technical difficulties or network interruptions in the Internet or in our managed IP network; . changes in the regulatory environment; and . general economic and competitive conditions specific to our industry. We believe that quarter-to-quarter comparisons of our historical operating results may not be a good indication of our future performance, nor would our operating results for any particular quarter be indicative of our future operating results. We may be unable to manage our expansion and anticipated growth effectively, which could reduce our chances of becoming profitable. Our rapid growth has placed, and is likely to continue to place, a significant strain on our managerial, accounting, operational, and financial resources. To manage our growth, we must continue to implement and improve our operational, accounting, and financial systems as well as our managerial controls and procedures. We cannot assure you that we will not suffer from unforeseen costs and risks associated with this expansion, that our systems, procedures, or controls will be adequate to support our operations, or that our management will be able to offer and expand our services successfully. We currently rely on a relatively small core management team. As we grow, we must not only manage demands on this team but also increase its resources so that it can continue to expand, train, and manage our employee base and maintain close coordination among our accounting, finance, marketing, and sales staff. If we are unable to manage our expanding operations effectively, our revenues may not increase, our cost of operations may rise, or we may not be profitable. The loss of one or more of our key customers would cause a significant decrease in our revenues. We have historically derived the majority of our revenues from a small number of customers, particularly Abest Communications and Abest International, collectively referred to as Abest, STE Communications, Goldman Network, and Star Communications. In the year ended September 30, 1999, Abest accounted for 44% of our revenues, STE Communications accounted for 14% of our revenues, and Goldman Network accounted for 11% of our revenues. For the six months ended March 31, 2000, Abest accounted for 7% of our revenues, Goldman Network accounted for 15% of our revenues, STE Communications accounted for 28% of our revenues, and Star Communications accounted for 23% of our revenues. None of our customers is obligated to purchase additional products or services from us. We cannot be certain that present or future customers will not terminate or significantly reduce their purchasing arrangements with us. Any termination or reduction by those customers would seriously harm our business, financial condition, and results of operations. We are experiencing difficulties in collecting accounts receivable from our largest customer, and failure to collect this receivable could cause our revenues and future cash flows to decline. We are experiencing difficulties in collecting our accounts receivable from Abest. Abest was formerly our most significant customer, accounting for approximately 38%, 44%, and 7%, of our total revenues for the period from our inception through September 30, 1998, the year ended September 30, 1999, and the six months ended March 31, 2000, respectively. As of March 31, 2000, Abest owed us approximately $786,000, which was past due. We believe that non-payment is the result of a lack of liquidity at Abest. In January 2000, after we stopped selling to Abest, Tianrong Internet Products and Services acquired the assets of Abest but did not assume the liabilities of Abest. We cannot assure you that we will be able to collect this receivable. Accordingly, we have deferred recognition of the revenue on the outstanding uncollected receivable due from Abest at December 31, 1999, and we will recognize revenue on the outstanding receivable balance only when we collect cash from Abest or otherwise assess the collectibility of the receivable as probable. Deferred revenue related to the uncollected Abest receivable at March 31, 2000 represented approximately 26% of our total deferred revenue. Failure to collect this receivable balance will negatively impact our financial condition and future cash flows. We may experience difficulties in collecting future accounts receivable from distributors, which could result in decreased profits and harm our business. We primarily sell our calling cards to distributors who resell the cards to third parties who then sell the calling cards to end users. We extend credit to those distributors for the outstanding balances they owe us for these cards. We are obligated to provide services to the end users of the cards regardless of whether we collect the receivable balances from the distributors. The failure to collect a significant portion of our accounts receivable from the distributors will have a material adverse impact on our business, financial condition, results of operations, and cash flows. IP communications alternatives may not achieve widespread acceptance, which could cause our business to fail. Our ability to sell our services to end users, particularly in Asia, may be inhibited by the reluctance of some end users to switch from traditional communications carriers to IP communications carriers and by concerns about the quality of Internet and Internet telephone services and the adequacy of security in the exchange of information over the Internet. End users in markets serviced by recently deregulated telecommunications providers are not familiar with obtaining services from competitors of these providers and may be reluctant to use new providers such as our company. In addition, international and domestic telecommunications rates are declining, which in turn is reducing the competitive pricing advantage that Internet telephone services provide to end users. IP communications may not prove to be a satisfactory alternative to traditional telephone service for reasons including: . inadequate development of the necessary infrastructure; . lack of acceptable security technologies; and . lack of timely development and commercialization of performance improvements. Our ability to generate revenues from business long distance and enhanced communications services depends on the migration of traditional telephone network traffic to our IP network. We will need to devote substantial resources to educating end users about the benefits of IP communications solutions in general and our services in particular, and as a result, we expect to incur significant expenditures for advertising and marketing activities in 2000. Potential end users who have already invested substantial resources in traditional telephone service may be reluctant or slow to adopt a new technology that makes their existing equipment obsolete. If end users do not accept our business long distance and enhanced communications services as a means of sending and receiving communications, we will not be able to increase our number of users or generate revenues from those services in the future. In particular, critical issues such as security, reliability, cost, ease of deployment, administration, and quality of service may affect the adoption of Internet telephone services as the means to meet business needs in Greater China and other parts of Asia. We will need additional capital to finance our operations in the future, and it may not be available on acceptable terms or at all, which could force us to limit or cease our operations. We intend to continue to enhance and expand our network to maintain our competitive position and meet the increasing demands for service quality, capacity, and competitive pricing. The introduction of our new business long distance and enhanced communications services will require significant marketing and promotional expenses. If our cash flow from operations and the proceeds of this offering are not sufficient to meet our capital expenditure and working capital requirements, we will need to raise additional capital. Raising capital may require us to issue additional equity, which could cause investors to experience dilution. We cannot assure you that any other source will be willing or able to provide additional capital on acceptable terms or at all. If we are unable to obtain additional capital, we may be required to reduce the scope of our business or our anticipated growth, which would reduce our revenues. Because we are dependent on our suppliers for our continued operations, our business could be materially harmed by the unavailability of certain equipment, delays, or increased costs. We are dependent upon our suppliers of equipment and software, including Cisco routers, Clarent gateways and software, Oracle software, and Sun Microsystems servers to develop and maintain our network and services. If our suppliers cease to provide us with the equipment and software necessary for the operation of our network or to maintain our current equipment, we may not be able to identify alternate sources of supply in a timely fashion. Any transition to alternate suppliers would be likely to result in delays, operational problems, or increased expenses and may limit our ability to provide services to our users or expand our operations. Because we rely on our U.S. and Asian telecommunication service providers for network access and termination services, any disruptions in service or problems with service providers could harm our operations. We rely on our telecommunication service providers to interconnect for access and termination to carry our traffic, including consumer long distance traffic. In Hong Kong, we rely on Cable & Wireless HKT, which has no competitors. The interconnection agreements for access and termination with our telecommunication service providers have a term of one year or less. Our current providers, especially our non-U.S. providers, could deny service to us in the future. In the event that we are unable to continue obtaining service from our current providers, our operations could be harmed. All of our current telecommunications service providers either are or could become potential competitors, which may lead them to increase prices or refuse to offer us future services. If our network is unable to accommodate our capacity needs, this may damage our reputation, which could result in a loss of customers. We expect the volume of traffic we carry over our network to increase significantly as we expand our operations and service offerings. Our network may not be able to accommodate this additional volume. If the usage of IP communications services grows, our managed IP network may not be able to support the demands placed on it by that growth, and its performance or reliability may then decline. To ensure that we are able to handle additional traffic, we may have to enter into long-term agreements for leased capacity. To the extent that we overestimate our capacity needs or the prices for capacity decrease, we may be obligated to pay for more transmission capacity than we actually use or to pay higher prices for the capacity we use, resulting in costs without corresponding revenues. As we expand our network, we will incur lease line, testing, and quality assurance costs. On the other hand, if we underestimate our capacity needs, we may be required to obtain additional transmission capacity from more expensive sources. Increased demand causes traffic overflow onto higher cost traditional telephone networks, which would increase, and has increased, our effective cost per minute. If we are unable to maintain sufficient capacity to meet the needs of our users, our reputation could be damaged and we could lose users. Damage to our systems and network could interrupt service and result in reduced revenues and harm to our reputation. Our business depends on the efficient and uninterrupted operation of our computer and communications systems as well as those that connect to our network. We maintain communications systems in Southern California and Taiwan, which are seismically active regions. In addition, our systems and those that connect to our network are subject to disruption from other natural disasters, or other sources of power loss, communications failures, intentional acts of vandalism, hardware or software malfunctions, network failures, and other events both within and beyond our control. Any system interruptions that cause our services to be unavailable, including significant or lengthy telephone network failures or difficulties for users in communicating through our network or our website, could damage our reputation and result in a loss of users. Our computer systems and operations may be vulnerable to security breaches, which may cause interruptions of our operations, damage to our reputation, and potential liabilities. Our operations depend on the integrity and security of our network and systems and our ability to protect them from unauthorized access, modifications, or use by third parties. Our computer infrastructure is potentially vulnerable to computer viruses, break-ins, and similar security breaches that could cause interruptions, delays, or loss of services to our users. We believe that the secure transmission of confidential information, such as credit card numbers, over the Internet is essential in maintaining user confidence in our services. We rely on licensed encryption and authentication technology to effect secure transmission of confidential information. It is possible that advances in computer capabilities, new technologies, or other developments could result in a compromise or breach of the technology we use to protect confidential information. A party who is able to circumvent our security systems could misappropriate proprietary information or cause interruptions in our operations. Security breaches also could damage our reputation, result in the expenditure of significant financial and managerial resources, and expose us to a risk of loss, litigation, or liability. Potential third party infringement of our intellectual property may cause harm to our business and competitive ability. To protect our rights to our intellectual property, we rely on a combination of trademark and trade secret laws and confidentiality agreements and other contractual arrangements with our employees, affiliates, strategic partners, and others. We do not currently own any issued patents. We may be unable to prevent or detect the unauthorized use of, or to enforce effectively, our intellectual property rights. In addition, effective trademark, copyright, and trade secret protection may not be available in every country in which we offer or intend to offer our services. We cannot assure you that any steps we take to protect our intellectual property rights will be sufficient or effective. Failure to protect our intellectual property adequately could harm our brand, devalue our proprietary content, and affect our ability to compete effectively. Defending our intellectual property rights could result in the expenditure of significant financial and managerial resources. Our services may infringe the intellectual property of third parties, which may result in expensive and time-consuming litigation. Third parties may assert claims that we have infringed a patent, copyright, trademark, or other proprietary right belonging to them. If we are found liable for infringement, we may have to pay damages or royalties to a third party or be unable to offer the portion of our services that is found to be infringing. Redesigning these services to avoid the infringement could result in the expenditure of significant financial and managerial resources. Defending against any infringement claims, even those that are not meritorious, could result in the expenditure of significant financial and managerial resources. Competition for highly skilled personnel is intense, and a failure to attract, retain, and manage key personnel may threaten our future success. Competition for qualified employees and personnel in the communications services industry is intense, and there are a limited number of people with knowledge of and experience in this industry, particularly in Asia. As we continue to grow, we will need to hire additional personnel in all areas. In particular, we will need to hire additional sales and marketing personnel to expand sales to corporate customers if and when we roll out our CommPortal product in Asia. Our success depends to a significant degree upon our ability to attract and retain qualified management, technical, and sales and marketing personnel and upon the continued contributions of our existing management and personnel. In particular, our success is highly dependent upon the abilities of our senior management, particularly Alex Liu, our chief executive officer, Steven San Eng, our executive vice- president of corporate development, James Courtney, our chief operating officer, and Mark Keithley, our chief financial officer. The loss of the services of any one of these individuals could have a material adverse effect on our business, financial condition, and results of operations. We do not have employment agreements with any of our executive officers or maintain key person insurance on them. If we do not develop the oCen brand, we may not be able to secure and maintain a leading position in our industry. To secure a leading position in our industry, we must strengthen the awareness of the oCen brand. If we fail to create and maintain brand awareness, it could adversely affect our ability to sell consumer long distance services, wholesale carrier transmission services, and business long distance and enhanced communications services or reduce our attractiveness to potential partners. Brand recognition may become more important in the future with a growing number of IP communications providers. Risks Related To Our Asian Operations Operating internationally exposes us to risks from unpredictable political, legal, and economic developments in foreign countries. For the six months ended March 31, 2000, approximately 88% of our traffic was terminated in Asia, generating approximately 93% of our revenues during the six months ended March 31, 2000. We intend to continue to enter additional markets in Asia and to expand our existing operations outside the United States, specifically in East Asia including Taiwan, Hong Kong, and the People's Republic of China. International operations are subject to inherent risks, including: . political, social, and economic instability; . potentially weaker protection of intellectual property rights; . unexpected changes in regulatory requirements and tariffs including any that would reduce the cost benefits that Internet telephone services currently provide; . export restrictions; . fluctuations in exchange rates and imposition of exchange controls; . varying tax consequences; . historical corruption and close ties between governments and state-owned monopolies; . limitations of communications infrastructures in some foreign countries; . uncertain market acceptance of the Internet, particularly in Asia; and . difficulties in marketing efforts because of cultural differences. Volatility in economic, social, and political conditions in Asia may interrupt, limit, or otherwise adversely affect our operations. We expect to derive a substantial portion of our future revenues from Asian markets. For the six months ended March 31, 2000, we generated 4% of our revenues from Asia-originated traffic. In 1998, many countries in Asia began to experience significant economic downturns and related difficulties, including: . reduced or even negative economic growth rates; . substantial currency depreciations; . high interest rates; . corporate bankruptcies; . declines in the market values of shares listed on stock exchanges and other assets; . reduced foreign investments in those countries; and . government-imposed austerity measures. As a result, there was a general decline in business and consumer spending and a decrease in economic growth as compared to prior years. The economic downturn in Asia has not significantly slowed, and future economic developments in countries throughout Asia could materially adversely affect our business, financial condition, and results of operations. Volatility has historically been caused by: . significant governmental influence over many aspects of local economies; . political instability; . unexpected changes in regulatory requirements; . social unrest; . imposition of trade barriers; and . wage and price controls. We have no control over these matters. Volatility resulting from these matters may create uncertainty regarding our operating climate or adversely affect our customers' operating budgets, which may adversely impact our business. We may be forced to discontinue our operations in China as a result of the uncertain legal status of our operations there. For the six months ended March 31, 2000, 68% of our traffic was terminated in China, and 77% of our revenues was generated from traffic terminated in China. In addition, as of March 31, 2000, approximately 4% of our assets was located in China. As a foreign investor, we are not permitted to provide telephone services in China. We believe that we are permitted to supply equipment and then enter into consulting or technical support agreements with Chinese providers. To offer services in China, we must therefore develop and maintain strategic partnerships with communications providers who are licensed to operate in China. We may not be able to form or maintain these strategic relationships in China or to structure our relationships with Chinese companies in the manner most advantageous to us. Moreover, our operations in China are subject to strict government scrutiny, and Chinese government officials may disagree with our understanding that we are allowed to operate in China through partnerships. Adjustments in policies of the Chinese government or changes in laws and regulations could adversely affect our business. Payment under business arrangements may be subject to currency risk and foreign exchange control in China. We expect to derive a significant portion of our revenues from our business activities in China. These business activities will be subject to Chinese rules and regulations on currency conversion. Exchange rate fluctuations of the Renminbi, the currency of Mainland China, may adversely affect our operations. The Renminbi fluctuates because of changes in Chinese government policies and international economic and political developments. In early 1994, the Renminbi experienced a devaluation against most of the major currencies. We cannot assure you that the Renminbi will not become volatile or that it will not be devalued by the Chinese government. In the future, we may face restrictions on settlement of current account transactions in currencies other than the Renminbi. For foreign exchange transactions under capital accounts, such as capital contributions and purchase of fixed assets, Chinese law imposes restrictions on the receipt and payment of currencies other than the Renminbi and requires prior approval from the State Administration of Foreign Exchange. We cannot assure you that our business partners in China will be able to freely pay us in any currency other than the Renminbi or that if we are paid in Renminbi, we will be able to remit the Renminbi payments out of China. If China does not become a member of the World Trade Organization, the Chinese regulatory environment may liberalize more slowly than expected or not at all, which could prevent us from expanding our operations in China. We cannot assure you that China will honor or fulfill its agreements to gradually open up the telecommunications sector to foreign investment upon its accession to the World Trade Organization. In addition, we cannot assure you that issuance of additional detailed regulations intended to open up the telecommunications sector to foreign investment will actually allow foreign ownership in telecommunications-related businesses in China. If China continues to limit or prohibit foreign investment in telecommunications businesses, we may be unable to expand our operations as planned. If we are unable to expand our operations by direct investment, our growth may be slowed and our results of operations may be materially adversely affected. To expand, we may be forced to continue to rely on foreign partnerships. This reliance creates difficulty in managing our operations, which may harm our results of operations or limit our rate of growth. The telecommunications infrastructure in China is developing and may not be reliable. Access to the Internet is accomplished primarily by means of the government's backbone of separate national interconnecting networks that connect with the international gateway to the Internet. This backbone is owned by the Chinese government and is the only channel through which the domestic Chinese Internet networks can connect to the international Internet network. Almost all access to the Internet is accomplished through ChinaNet, China's primary commercial network, which is owned and operated by the Chinese government. Internet users have no means of getting access to alternative networks and service in the event of any disruption or failure. We cannot assure you that the Internet infrastructure in Greater China will support the demands associated with continued growth. If the necessary infrastructure standards or protocol or complementary products, services, or facilities are not developed, our business could be materially adversely affected. The legal framework for telecommunications businesses in China is developing and may change in ways that would adversely affect our ability to operate and grow our business. The legal framework governing the telecommunications industry in China is not well established and may change. We cannot predict the effect of further developments in the Chinese legal system, particularly with regard to the Internet, including the promulgation of new laws, changes to existing laws or their interpretation or enforcement, or the preemption of local regulations by national laws. In particular, the interpretation and enforcement of existing laws and regulations may change. If the Chinese government should at any time construe existing laws against Internet-related businesses more strictly or enact new laws dealing with Internet-related businesses, our business could be materially adversely affected. The issuance of new regulations from various governmental departments may result in overlapping mutually contradictory regulations. This situation could result in uncertainty for business operations of Internet companies in China and add to the complexity and intrusiveness of the regulatory environment in which Internet companies operate. Doing business in Taiwan subjects us to unpredictable risks from increased Chinese involvement and to risks that Taiwan may not emerge from recession and that the NT dollar may depreciate. For the six months ended March 31, 2000, 10% of our traffic was terminated in Taiwan, and 7% of our revenues was generated from traffic terminated in Taiwan. In addition, as of March 31, 2000, 3% of our assets was located in Taiwan, including a data center. In the future, we expect to generate a significant portion of our revenues from originating traffic in Taiwan. China asserts sovereignty over mainland China and Taiwan but does not exercise jurisdiction or control over Taiwan. China does not recognize the legitimacy of the Taiwan government. The Chinese government has indicated that in spite of the significant economic and cultural relations established during recent years between Taiwan and China, it may use military force to gain control over Taiwan if Taiwan declares independence or if any foreign power interferes in Taiwan's affairs. Adverse relations between Taiwan and China and other factors affecting the political or economic conditions of Taiwan could negatively affect our business and the market price and liquidity of our shares. If China increases its level of control in the affairs of Taiwan, the increased regulation, and even the uncertainty from increased control, may hinder our operations and adversely affect our business. Between late 1997 and early 1999, the NT dollar, the currency of Taiwan, experienced considerable volatility and depreciation as a result of the economic downturn in Asia. Continued volatility and depreciation of the NT dollar could harm our business. Taiwan has recently experienced a recession primarily due to a reduction in exports due to weakened demand for imported goods in many Asian countries. A continued recession in Taiwan may adversely affect our business. Our subsidiary in Taiwan may be subject to investigation and penalties for selling Internet telephone services to customers in Taiwan without the appropriate license. Taiwan commenced its deregulation of the Internet and telecommunications fields in 1996. Current Taiwan law requires cellular phone, satellite communications, and fixed communication network operators to obtain licenses to operate. The Directorate General of Telecommunications regulates the telecommunications industry under the Telecommunications Law and other regulations. Our Taiwan subsidiary is considered an Internet service provider and, as such, must be granted a type II license in order to conduct our business. As a type II license holder, we are not permitted to offer Internet telephone services in competition with a type I license operator until after July 2001. On September 7, 1998, the Directorate issued a news release that warned all Internet service providers not to offer Internet telephone services because the type II license issued to those providers does not allow them to encroach on the services allowed to telecommunications network operators with a type I license. The Directorate confirmed its determination to investigate violations and invoke penalties under the Telecommunications Law. If the Taiwanese government's announced deregulation does not occur in 2001 or if our partner in Taiwan has not obtained or maintained the proper license required after deregulation, we may not be able to offer services in Taiwan. This limitation would materially adversely affect the financial condition, operating results, and future prospects of our business in Taiwan. In addition, our wholly-owned subsidiary in Taiwan sells the equipment to obtain access to Internet telephone services, which is permitted under Taiwan law, and sells Internet telephone services to customers in Taiwan, which is not permitted for a type II operator under Taiwan law until July 2001. Our subsidiary has applied for but has not yet received a type II license. Thus, based on the announced regulatory policy of the Directorate General, our subsidiary in Taiwan may be subject to investigation and penalties for offering Internet telephone services without a type II license. Furthermore, once our Taiwan subsidiary obtains a type II license, it may be subject to investigation and penalties for offering those services prior to the scheduled deregulation of type II license operators. Doing business in Hong Kong subjects us to unpredictable risks from increased Chinese involvement and the risk that the Hong Kong economy may worsen. For the six months ended March 31, 2000, 3% of our traffic was terminated in Hong Kong, and 2% of our revenues was generated from traffic terminated in Hong Kong. In addition, as of March 31, 2000, 4% of our assets was located in Hong Kong. These assets include a data center. Hong Kong is a special administrative region of China with its own government and legislature. We cannot assure you that Hong Kong will continue to maintain autonomy from China. If China increases its level of control in the affairs of Hong Kong, the increased regulation, and even the uncertainty from increased control, may hinder our operations and adversely affect our business. Since mid-1997, interest rates in Hong Kong have risen significantly, real estate and retail sales have declined, and Hong Kong has slipped into a recession. In early 1999, Hong Kong suffered deflation, and the Hong Kong dollar was subject to currency speculation. We cannot assure you that the Hong Kong economy will not worsen or that the 17-year historical currency peg of the Hong Kong dollar to the U.S. dollar will be maintained. Recession in Hong Kong, deflation, or the discontinuation of the historical peg could adversely affect our business. The legal framework with respect to the Internet and telecommunications is developing in Hong Kong and may evolve in ways adverse to our business. In Hong Kong, only a few pieces of legislation are directly applicable to Internet-related businesses. It is possible that the legislature may introduce new laws covering issues such as content, copyright, distribution, and quality of products and services. The enactment of any new laws or regulations may hinder the growth of our consumer long distance and wholesale carrier transmission services businesses or our other prospective business activities. In addition, changes in Hong Kong's telecommunications policies, including any policy change regarding competition, could have a material adverse effect on our business. The introduction of any new laws and regulations or changes to existing laws and regulations that restrict our ability to operate or that lead to increased compliance costs would have a material adverse impact on our business. In particular, operations set up on the basis of a current understanding of the legislative regime may, in the event of a misinterpretation of applicable law or practice, any changes in that law or practice, or a change in its interpretation or enforcement policy, result in the established operations being, or being deemed to be, in breach of law or subject to new or additional requirements. If our operations cannot be modified to conform to the then applicable law or practice or its interpretation, we may be unable to conduct this part of our business. Our business in Hong Kong is regulated by the Office of the Telecommunications Authority of Hong Kong. Any additional restrictions or conditions that the Authority imposes on our Hong Kong business may materially adversely affect our results of operations. Our subsidiary in Hong Kong currently operates with a public non-exclusive telecommunications service license that was renewed in April 2000 and must be renewed every 12 months. We cannot assure you that we will be able to maintain and renew this license. Our license could be cancelled or withdrawn at any time, or suspended for up to 12 months, for violating a telecommunications ordinance or provisions of our license. Our license could also be cancelled or suspended if the Authority considers it in the public interest. Our inability to do business in Hong Kong could materially adversely affect our business. Failure to maintain our telecommunications license in Hong Kong could subject us to fines and imprisonment and would prevent us from doing business in Hong Kong. Fluctuations in the values of foreign currencies could have a negative effect on our future profitability. In the course of our international operations, we incur expenses in a number of currencies. In the future, as we expand by providing business long-distance and enhanced communications services, we may also receive revenues in foreign currencies. We do not currently engage in currency hedging activities to limit the risks of exchange rate fluctuations. Fluctuations in the value of foreign currencies could have a negative impact on our global operations, which would harm our business, financial condition, and results of operations. In addition, fluctuations in the value of the U.S. dollar against foreign currencies may make our products and services more expensive than local product offerings. Risks Related to the IP Communications Industry Intense competition could reduce our market share and harm our financial performance. Competition in the market for communications services is becoming increasingly intense and is expected to increase significantly in the future from a variety of companies both in the Internet and telecommunications industries including traditional telecommunications carriers, Internet service providers and Internet communications services providers. These and other competitors may be able to bundle services and products that we do not offer with enhanced communications services, which could place us at a significant disadvantage. Many of these companies have greater resources and larger subscriber bases than we have and have been in operation longer. We compete in the growing market for competitively priced consumer long distance services, including calling cards, call-back services, dial-around or 10-10 calling, and collect calling services. We also compete with telecommunications providers, long distance carriers, and other long distance resellers and providers of carrier services for our wholesale carrier transmission services. If we are unable to provide competitive service offerings, we may lose existing users and be unable to attract additional users. In addition, many of our competitors, especially traditional carriers, enjoy economies of scale that result in a lower cost structure for transmission and related costs, which causes significant pricing pressures within the industry. This pricing pressure has begun to negatively impact our gross margin. In addition, many of our Internet telephone services competitors use only the Internet, rather than a managed IP network, to transmit traffic. Operating and capital costs of these providers may be less than ours, potentially giving them a competitive advantage over us in terms of pricing. The Greater China and Asian IP communications market is intensely competitive and characterized by an increasing number of entrants because the start-up costs are low. In addition, the Asian telecommunications industry is relatively new and subject to continuing definition and as a result, our competitors may better position themselves to compete in this market as it matures. Recent and pending deregulation of some of these markets may further encourage new entrants. The Hong Kong telecommunications industry is also highly competitive. Companies compete in Hong Kong on the basis of price and quality. The heightened level of competition in Hong Kong may result in a further reduction in the prices for telecommunications services in the Hong Kong market. If pricing pressures continue, this situation may have a material adverse effect on the future growth and profitability of our Hong Kong business. Existing and future competition may adversely affect our results of operations. In addition to these competitive factors, recent and pending deregulation in some of our markets may encourage new entrants. We cannot assure you that additional competitors will not enter markets that we plan to serve or that we will be able to compete effectively. Decreasing telecommunications rates may diminish or eliminate our competitive pricing advantage. Decreasing telecommunications rates may diminish or eliminate the competitive pricing advantage of our consumer long distance services services and wholesale carrier transmission services. International and domestic telecommunications rates have decreased significantly over the last few years in most of the markets in which we operate, and we anticipate that rates will continue to decline in all markets. Users who select our Internet telephone services to take advantage of the current pricing differential between traditional telecommunications rates and our rates may switch to traditional telecommunications carriers as pricing differentials diminish or disappear. We will be unable to use pricing differentials to attract new customers in the future. In addition, our ability to market our consumer long distance services services to customers depends upon the existence of spreads between the rates offered by us and the rates offered by traditional telecommunications carriers as well as a spread between the retail and wholesale rates charged by the carriers from which we obtain wholesale service. Continued rate decreases will require us to lower our rates to remain competitive and will reduce or possibly eliminate our gross profit from our consumer long distance services. If telecommunications rates continue to decline, we may lose users of our consumer long distance services and may not be able to generate revenues from our other Internet telephone services. Because the margins on our consumer long distance services are continuing to decline, we must develop and introduce our business long distance and enhanced communications services on a timely basis to achieve long term profitability. U.S. government regulation and legal uncertainties relating to Internet telephone services could harm our business. Changes in the regulatory environment in the United States could have a material adverse impact on our business. Traditionally, voice communications services were provided by regulated telecommunications common carriers over traditional telephone networks. We offer voice communications to the public for international calls over data networks. We believe that our Internet telephone services presently satisfy the legal and regulatory definitions of information services. However, the Federal Communications Commission, which regulates interstate and international communications in the United States, has never ruled on the regulatory classification of our Internet telephone services or of Internet telephone services generally. There is therefore uncertainty as to the present legal status of our services. Moreover, there could be at any time a determination of the regulatory classification of our Internet telephone services as a result of future regulatory action, judicial decisions, or legislation in any of the jurisdictions in which we operate. In particular, the FCC could issue a decision addressing the regulatory status of Internet telephone services. The FCC has said that Internet telephone services appear to have many characteristics of a telecommunications service. If the FCC ultimately determines that Internet telephone services are, or shares many characteristics with, a telecommunications service, the FCC could regulate Internet telephone services as a telecommunications service or otherwise subject Internet telephone services to increased regulation. Much of the impetus for regulatory change could come from established regulated telecommunications carriers who have sought and may continue to seek regulatory, legislative, and judicial actions to restrict the ability of companies such as ours to provide Internet telephone services or to increase the cost, through additional regulatory burdens, of providing those services. Whatever the impetus, one area of increased regulation could focus on the distinction between phone-to-phone telephone service over managed IP networks on the one hand and integrated PC-to-PC and PC-originated voice services over the Internet on the other hand. Changes in laws or regulations could require the former to be regulated as telecommunications services while leaving the latter as unregulated information services. Since we offer phone-to-phone Internet telephone services over managed IP networks, that kind of decision could have a material adverse effect on our business. Application of new regulatory restrictions or requirements could materially increase our costs of doing business in other ways as well or, in some circumstances, even prevent our provision of certain services. For example, if our Internet telephone services become subject to the international settlement rate regime or access charges, the material increase in our costs could offset the competitive advantage we have over traditional international carriers. If other regulatory changes prevent us from delivering our services under our current arrangements, we would have to consider alternate arrangements for providing our services, including changing our service arrangements with partners or limiting our service offerings. Other changes in law or regulation could similarly limit our service offerings, raise our costs, restrict our pricing flexibility, and limit our ability to compete effectively. Regulations and laws that affect the growth of the Internet could likewise hinder our ability to provide our services over the Internet. Recent international regulatory proposals, if implemented, could harm our business. A policy committee of the International Telecommunications Union, the international body that coordinates international communications regulations, has recently proposed that Internet telephone services be subject to international settlement rates. That recommendation, if implemented, could increase the cost of our service and make us less competitive with traditional telecommunications carriers. Although some of our customers may be using our calling cards to make intrastate long distance calls, we are not authorized to provide intrastate telecommunication services in all fifty U.S. states. We are currently authorized to provide intrastate services only in New York and California. Because these authorizations were obtained when we were incorporated in California under the name Pacific Telekey Network, we must obtain the prior approval of those state public utility commissions before we can provide intrastate long distance services as a Delaware corporation under the name oCen Communications. If our customers use our calling cards to make intrastate telephone calls, we would be providing intrastate telecommunication services without state authorization. Providing those services could be deemed unlawful and could result in fines, penalties, and other sanctions, including an order from a state public utility commission to cease operations in the state for some period of time. If we were ordered to cease operating in a state, it could have a material adverse effect on our business. If we are unable to keep pace with rapid technological changes in the communications industry, our revenues will decrease. Our industry is subject to rapid technological change and evolving industry standards. We cannot predict the effect of technological changes on our business. We expect that new services and technologies will emerge in the markets in which we compete. These new services and technologies may be superior to the services and technologies that we use, or these new services may render our services and technologies obsolete. In addition, widely accepted standards have not yet developed for the technologies we use. To be successful, we must adapt to our rapidly changing markets by continually improving and expanding the scope of services we offer and by developing new services and technologies to meet customer needs. Our success will depend, in part, on our ability to license or acquire leading technologies to develop our business long distance and enhanced communications services and to respond to technological advances and emerging industry standards on a cost- effective and timely basis. We will need to spend significant amounts of capital to enhance and expand our services to keep pace with changing technologies or our revenues will decline. Risks Related To This Offering Stock prices of Internet-related companies have fluctuated widely in recent months, and the trading price of our common stock is likely to be volatile, which could result in substantial losses to investors. The trading price of our common stock is likely to be volatile and could fluctuate widely in response to a number of factors, some of which are beyond our control. For a list of these factors, see "Risk Factors--Potential fluctuations in our quarterly financial results could make it difficult for investors to predict our future performance, which may cause our stock price to be volatile and decline." In particular, following initial public offerings, the market prices for stocks of Internet and technology-related companies often reach levels that bear no established relationship to the operating performance of these companies. The market prices of the securities of Internet-related and online companies have been especially volatile. These broad market and industry factors may significantly harm the market price of our common stock, regardless of our actual operating performance. In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. Securities class action litigation, if initiated against us, could result in substantial costs and the diversion of our management's attention and resources. Sales of additional shares of our common stock into the public market may cause our stock price to fall. Sales of substantial amounts of our common stock in the public market after this offering or the perception that substantial sales could occur may adversely affect the prevailing market price of our common stock. These sales also might make it difficult for us to sell equity securities in the future at a time and price that we deem appropriate. Upon completion of this offering, we will have 18,497,885 shares of common stock outstanding or 19,067,885 shares of common stock outstanding if the underwriters exercise their over-allotment option in full. This amount includes 3,800,000 shares we are selling in this offering, which may be immediately resold in the public market. The holders of the remaining shares have "demand" and "piggyback" registration rights, and these shares will become eligible for resale 180 days following the date of this prospectus, subject to Rule 144 under the Securities Act of 1933, as amended. We, our officers, directors, and some existing stockholders have agreed that without the prior written consent of Lehman Brothers, we and they will not, directly or indirectly, offer, sell, or otherwise dispose of any shares of capital stock or any securities that may be converted into or exchanged for any shares of capital stock for a period of 180 days from the date of this prospectus. In addition, as soon as practicable after the date of this prospectus, we intend to file a registration statement on Form S-8 with the Securities and Exchange Commission covering the shares of common stock reserved for issuance under our 1998 and 2000 stock option plans and our 2000 employee stock purchase plan. We expect the additional registration statement to become effective immediately upon filing. Sales of a large number of shares could have an adverse effect on the market price of our common stock. Provisions of our certificate of incorporation, bylaws, and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. Provisions of our certificate of incorporation and bylaws impose various procedural and other requirements, including the existence of a classified board of directors with staggered, three-year terms, that could make it more difficult for third parties to acquire us or for stockholders to effect certain corporate actions. Upon consummation of the offering, our certificate of incorporation will allow our board of directors to issue up to shares of preferred stock and to fix the rights, privileges, and preferences of these shares without any further vote or action by the stockholders. The rights of the holders of our common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that we may issue in the future. While we have no present intention to issue shares of preferred stock, any issuance could be used to discourage, delay, or make more difficult a change in control of us. In addition, our certificate of incorporation imposes restrictions on calling special meetings of stockholders and prohibits stockholder action by written consent. Our bylaws impose restrictions on introducing stockholder proposals. Each of these features could also be used to discourage, delay, or make more difficult a change in control of us. See "Description of Capital Stock." Minority stockholders may not be able to elect any of our directors, which could deter a takeover even if beneficial to our stockholders. Following the offering, our existing stockholders will, in the aggregate, beneficially own 79% of our common stock. These stockholders will be able to exercise control over all matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying or preventing a change in control of our company, which could have a material adverse effect on our stock price. You will face immediate and substantial dilution in net tangible book value. The initial public offering price of our common stock is expected to exceed substantially the tangible net book value per share of the common stock immediately after this offering. As an investor in this offering, you will pay $13.00 per share, and the net tangible book value per share is expected to be $2.84 immediately after the offering. The net tangible book value per share represents the amount of our total assets less total liabilities, divided by the number of shares of common stock outstanding immediately after the offering. In addition, to the extent that outstanding options and warrants to purchase common stock are exercised, there could be substantial additional dilution. Furthermore, investors in this offering will contribute approximately 86% of our net tangible assets but will own only approximately 21% of the company.

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+RISK FACTORS This offering involves a high degree of risk. You should carefully consider the risks described below and the other information in this prospectus, including our financial statements and the notes to those statements, before you purchase any common shares. Additional risks and uncertainties, including those generally affecting the market in which we operate or that we currently deem immaterial, may also impair our business. The information in this prospectus includes forward-looking statements that involve risks and uncertainties. These statements refer to our future plans, objectives, expectations and intentions. These statements may be identified by the use of words such as "believes," "may," "will," "expects," "anticipates," "intends," "plans" and similar expressions. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those discussed in this section and in the sections of this prospectus entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business." Risks Related to Our Business Our limited operating history makes it difficult to predict our future success. Our business has evolved, making predictions of future profitability even more difficult. We were organized in November 1995 and commenced operations in February 1996 to provide securities compliance filing services to the financial, business and legal communities. Since then our business has expanded so that we now offer a variety of services. Accordingly, we have a limited operating history upon which you can evaluate our business and prospects. You should evaluate our chances of financial and operational success in light of the risks, uncertainties, expenses, delays and difficulties associated with starting a new business in the rapidly changing and highly competitive Internet professional services market, many of which may be beyond our control. Our services are being marketed to niche markets and it is uncertain whether the principal participants in these markets will change their existing methods of doing business. We plan to aggressively market our proprietary format for distributing investment and offering documents online to the real estate investment banking and investment banking industries. We also intend to aggressively market our Web site development services to regional investment banks as they migrate to the Internet. We do not expect that investment banks will purchase our services without intensive sales and marketing efforts. Various factors could adversely affect our efforts, including overcoming concerns about security issues and a general reluctance to move away from traditional methods of doing business. Our potential customers may have a substantial investment in their current production and distribution methods and may be reluctant to adopt a new approach that will compete with or replace their existing methods. The emerging market for Internet professional services is relatively new and there is no assurance that it will continue to grow. The market for Internet professional services has only recently begun to develop, is rapidly evolving and is characterized by an increasing number of market entrants. The market for our services is new and rapidly evolving. Therefore, it is difficult to predict with any assurance whether such services will achieve or maintain commercial acceptance or the growth rate or the ultimate size of the market. If the market fails to develop, develops more slowly than expected, or becomes saturated with competitors, our products and services do not achieve market acceptance, or our pricing becomes subject to significant competitive pressures, our business, results of operations and financial condition would be materially and adversely affected. Our business could be materially and adversely affected by a downturn in the financial and real estate markets. Most of our revenues are derived from companies in the financial services and real estate industries. Our growth thus far reflects the recent strength of the capital markets, both public and private, and the real estate market. If the capital markets were to contract, the number of securities compliance filings would probably decrease, as would the number of private placements and public offerings. The real estate market also would be negatively affected, decreasing investor demand. Our quarterly financial results are subject to significant fluctuations due to many factors, any of which could adversely affect our stock price. Our revenues and operating results may vary significantly from quarter to quarter and, therefore, quarter to quarter comparisons of our operating results may not be meaningful and may not be indicative of our future performance. It is possible that our operating results may fall below the expectations of analysts and investors. Any decline in revenues or earnings or a greater than expected loss for any quarter could cause the market price of our common shares to decline. The factors, some of which are outside our control, which may cause our financial results to vary from quarter to quarter include: o the number, size and scope of our client engagements; o unanticipated delays, deferrals or cancellations of client engagements or unanticipated changes in the scope of major client engagements; o the efficiency with which we utilize our billable professionals, plan and manage our existing and new client engagements and manage future growth; o the extent to which we use subcontractors or hire new billable professionals whom we may not be able to immediately utilize on client engagements; o variability in market demand for Internet professional services; o our ability to attract qualified professionals in a timely and effective manner; o our ability to complete fixed-fee engagements on budget; o changes in pricing policies by us or our competitors; and o general economic conditions. We generate a large portion of our revenues from a small number of clients. We derive a significant portion of our revenues from a limited number of clients. For example, in 1999 three clients accounted for 54.0% of our revenues, one of which accounted for approximately 36.0% of our revenues. We expect a relatively high level of client concentration to continue. The volume of work performed for these clients may not be sustained from year to year and there is a risk that these principal clients may not retain us in the future. To the extent that any significant client uses less of our services or terminates its relationship with us, our revenues in the relevant fiscal period could substantially decline and our operating results could be adversely affected. Our revenues are difficult to predict because they are generated on a project-by-project basis. Our revenues are derived primarily from project-based client engagements, which vary in size and scope. As a result, our revenues are difficult to predict from period to period. Our revenue growth and operating results would be adversely affected if we cannot secure new client engagements to replace completed projects. We perform work for clients without contracts or under contracts that are terminable upon little or no notice. Any termination could result in a loss. In general, our client contracts tend to be short-term agreements and may be terminated by the client upon 30, 60 or 90 days prior written notice. Furthermore, our clients can generally reduce the scope of an engagement without penalty and with little or no notice. If a client terminates a contract before we complete the project or reduces the scope of an engagement, we may be unable to recoup the revenues we would have earned had the contract not been terminated. Also, a substantial portion of our expenses, including those related to employee compensation and equipment, are relatively fixed. Consequently, if we cannot quickly enter into new agreements to replace the terminated agreements, we will continue to incur those costs without having the benefit of any related revenues. The loss of our founder and chief executive officer would make it difficult to implement our growth strategy, complete existing projects and bid for new projects. Our success depends on the continued services of our founder and chief executive officer, Anthony L. Willsea. If Mr. Willsea were unable or unwilling to continue to be actively involved in our business, our client relationships and our ability to implement our growth strategy, complete existing projects and bid for new projects could be severely impaired. We intend to enter into an employment agreement with Mr. Willsea prohibiting him from competing with us or soliciting our clients for a period of three years after his employment terminates. However, the enforceability of these restrictions has never been addressed by a court and we cannot assure that they will be upheld if challenged. Our executive management team has limited experience working together, which may make it difficult to conduct and grow our business. Most of our senior executive officers are relatively recent hires. Our chief marketing officer was hired in February 1999, and our executive vice president -- Internet/new media services and chief financial officer joined us in May 1999. Therefore, there has been little opportunity to evaluate the effectiveness of our executive management team as a combined unit. The failure of executive management to function effectively as a team may have an adverse effect on our ability to obtain and execute client engagements, maintain a cohesive culture and compete effectively in the marketplace. Our inability to attract, hire and retain qualified professionals could hinder our ability to serve our clients and implement our growth strategy. If we cannot attract, hire and retain the qualified Internet professionals and technical personnel that are integral to our business, we may not be able to complete existing projects, take on new projects or develop new products and services. We must continually recruit talented professionals in order for our business to grow. These professionals must have skills in business strategy, marketing, branding, technology and creative design. The Internet professional services market is labor intensive and currently there is a shortage of qualified technical personnel that is likely to continue into the foreseeable future. We may be unable to manage our growth. Our revenues for the year ended December 31, 1999 increased 51.5% over 1998 revenues. The number of our employees increased from 12 at January 1, 1997 to 43 at December 31, 1999. This rapid growth has placed, and our planned future growth will continue to place, a significant strain on our operational, managerial, technical and financial resources. We cannot assure you that we will be able to manage our growth effectively. To manage future growth, we must continue to improve our operational and financial systems, procedures and controls and expand, train, manage and retain our employees. In addition, our growth strategy contemplates strategic acquisitions as a means to acquire new talent and expertise and gain access to new markets. Acquisitions involve numerous risks and uncertainties including costs, delays and difficulties of integrating the acquired company's operations, technologies and personnel into our existing operations, organization and culture. We may need additional capital in the future, which may not be available to us. In the future, we may need to raise additional funds, either through public or private financings, to take advantage of expansion or acquisition opportunities, develop new services or compete effectively in the marketplace. Future liquidity and capital requirements will depend upon numerous factors, including the success of our existing and new services and competing technological and market developments. We may not be able to obtain additional financing when needed on favorable terms. We have not entered into any agreements to raise additional funds. We face intense competition and may be unable to compete effectively. The Internet professional services market is relatively new and highly competitive. We expect competition to further intensify as this market rapidly evolves. Increased competition could result in price reductions, reduced gross margins and loss of market share, any of which could have a material and adverse affect on our business, results of operations and financial condition. Many of our competitors have longer operating histories, larger client bases, longer relationships with their clients, greater brand or name recognition and significantly greater financial, technical and marketing resources than we do. Consequently, our competitors may be in a better position than we are to respond quickly to new or emerging technologies, address changes in client requirements, adopt more aggressive pricing policies, make attractive offers to potential employees and strategic partners and devote resources to the development, promotion and sale of products and services. Our competitors vary in size and in the scope and breadth of services offered. We believe that our primary competitors include the following companies: o Internet professional service firms including Scient, Viant, Razorfish, Proxicom, Sapient and USWeb; o technology consulting firms and integrators including the consulting affiliates of the major accounting firms, Diamond Technology Partners, EDS and IBM; o in-house information technology, marketing and design service departments of our current and potential clients; o multimedia production and entertainment companies including Digital Lava, Pacific Media and DigitalThink; o large financial printers including Merrill Corporation, Bowne, R.R. Donnelley & Sons and Global Financial Press; and o corporate filing services including ADP, CCH and Prentice Hall. In addition, the emergence of new competitors may pose a threat to our business. There are relatively low barriers to entry into the Internet professional services market. Existing or future competitors may develop and offer services that are superior to, or have greater market acceptance than ours. Our business may suffer and we may not be able to implement our growth strategy if we are unable to maintain our reputation and expand our name recognition. We believe that establishing and maintaining a strong reputation and increasing brand awareness of our products and services are critical for attracting and retaining clients and employees. We also believe that the importance of reputation and name recognition will increase due to the growing number of Internet professional services providers. In order to establish and maintain our good name and reputation, we must continue to provide secure, high quality, efficient service. In order to build brand awareness for our products and services, we must expand our marketing efforts. If third parties ever assert that we have infringed on their intellectual property rights or that our employees have misappropriated their proprietary information, we could incur substantial costs, experience diversion of management's attention and disruption of our business. Third parties may assert infringement claims against us in the future or claim that we have violated their intellectual property rights. We have recently settled one such claim. While we know of no basis for any future claims of this type, authorship of intellectual property rights can be difficult to verify. Competitors could assert, for example, that former employees of theirs whom we have hired have misappropriated their proprietary information for our benefit. Our business may suffer if we are unable to renew our software licensing for EDGARease(C) or if we have disputes over our right to reuse intellectual property developed for specific clients. Currently, we license EDGARease(C), a program that converts documents into the EDGAR ASCII format required by the SEC, from Document Technologies, Inc. If we are unable to maintain or renew such license, we would be forced to discontinue our use of this software and develop or license comparable technology which may not be available. In addition, when we develop software applications for discrete client engagements, we typically retain the right to reuse the applications, processes and other intellectual property we develop. Issues relating to the rights to intellectual property can be complicated, and disputes may arise that could adversely affect our ability to reuse these applications, processes and other intellectual property. These disputes could damage our relationships with our clients and our business reputation, divert our management's attention and have a material adverse effect on our ability to maintain or grow our business. Risks Related to Our Industry If we do not keep pace with changing technologies and client preferences, our current services may become obsolete or unmarketable. Our business and the Internet professional services market is characterized by rapidly changing technologies, evolving industry standards, frequent new product and service introductions, and changing customer demands. To be competitive and serve our clients effectively, we must respond on a timely and cost-efficient basis to changes in technology, industry standards and client preferences. We may experience technical or other difficulties that prevent or delay our responses. These delays could cause our current services to become obsolete and unmarketable. In addition, we may incur substantial costs if we need to modify our services or infrastructure in order to adapt to these changes. Our business depends on continued growth in the use of the Internet. If the usage and volume of commercial transactions on the Internet does not continue to increase, demand for our services may decrease and our business, results of operations and financial condition could materially suffer. The future of our business depends upon continued growth in Internet usage by our clients, prospective clients and their customers and suppliers. Growth in Internet usage has caused capacity constraints that may potentially impede further growth if left unresolved. The factors that may affect Internet usage or e-commerce adoption include: o actual or perceived lack of security of information; o congestion of Internet traffic or other usage delays; o inconsistent quality of service; o increases in Internet access costs; o increases in government regulation; o uncertainty regarding intellectual property ownership; o reluctance to adopt new business methods; o costs associated with the obsolescence of existing infrastructure; and o economic viability of e-commerce models. If the Internet infrastructure is not adequately maintained, we may be unable to provide our products and services in a timely manner. Our future success will depend, in substantial part, upon the continued development of the Internet technology infrastructure, including a reliable network backbone with the necessary speed, data capacity and security, and the timely development of enabling products, including high-speed modems, for providing reliable and timely Internet access and services. To the extent that the Internet continues to experience increased numbers of users, frequency of use or increased bandwidth requirements of users, the Internet infrastructure may not continue to support the demands placed on it and as a result, the performance or reliability of the Internet may be adversely affected. Furthermore, the Internet has experienced a variety of usage and other delays. The infrastructure and complementary products and services necessary to maintain the Internet as a viable commercial medium may not be developed or maintained. Moreover, critical issues concerning the commercial use of the Internet, including security, cost, ease of use and access, intellectual property ownership and other legal liability issues, remain unresolved and could materially and adversely affect both the growth of Internet usage generally and our business, results of operations and financial condition in particular. System failures may interrupt or delay our ability to provide our services and security breaches could be harmful to our reputation. The continued and uninterrupted performance and security of our computer, data and telecommunications systems is critical to our success. Any system failure that causes interruptions or delays in our ability to deliver our services to our clients could reduce customer satisfaction, damage our reputation and cause us to lose clients. Security breaches would also have a material adverse effect on us. We must protect our computer, data and telecommunications systems against viruses, vandalism, other malicious acts and similar unexpected adverse events. The occurrence of any of these events would cause us to be unable to operate our business for a substantial period of time or could harm our reputation. Although we carry general liability insurance, our insurance may not cover claims by dissatisfied customers or may not be adequate to indemnify us for any liability we may incur if we are the subject of a claim. Increasing government regulation could adversely affect our business. Due to the increasing popularity of the Internet, various laws or regulations relating to the Internet have been proposed or adopted and the application of existing laws and regulations to the Internet is being reviewed by various governmental agencies. An increase or change in federal, state or foreign legislation or regulation of e-commerce could hinder the Internet's growth and could decrease its usage as a commercial marketplace. If this decline occurs, existing and prospective clients may decide not to use our services. In addition, a number of legislative proposals have been made at the federal, state and local levels and by foreign governments that could impose taxes on online commerce. The three-year moratorium preventing state and local governments from taxing Internet access, taxing electronic commerce in multiple states and discriminating against electronic commerce is scheduled to expire on October 21, 2001. If the moratorium ends, state and local governments could impose these types of taxes or discriminate against electronic commerce. In addition, existing state and local laws that tax Internet related matters were expressly excluded from this moratorium. These regulations, and other attempts at regulating commerce over the Internet, could impair the viability of e-commerce and the growth of our business. Risks Related to this Offering The market price of our common shares could fluctuate significantly. The market price of our common shares could fluctuate significantly after this offering in response to a variety of factors, many of which may be beyond our control, including the following: o changes in financial estimates or investment recommendations by securities analysts following our business; o quarterly operating results falling below or exceeding analysts' or investors' expectations in any given period; o changes in economic and capital market conditions for Internet and other Internet professional service companies; o changes in market valuations of, or earnings and other announcements by, Internet professional services and other Internet technology companies; o announcements by us or our competitors of new service offerings, contracts, acquisitions or strategic relationships; o additions or departures of key personnel; and o changes in business or regulatory conditions. Many companies' equity securities, including the equity securities of Internet and other technology companies, have experienced extreme price and volume fluctuations in recent years. Often, these fluctuations are unrelated to the companies' operating performance. Elevated levels in market prices for securities, often reached following these companies' initial public offerings, may not be sustainable and may not bear any relationship to operating performances. Our common shares may not trade at the same levels as other Internet stocks, and Internet stocks in general may not sustain their current market prices. However, if investor interest in these stocks declines, the price for our common shares could drop suddenly and significantly, even if our operating results are positive. In the past, following periods of market volatility, stockholders have instituted securities class action litigation. If we were involved in securities litigation, we could incur a substantial cost and experience diversion of resources and the attention of management away from our business. We are controlled by a single shareholder. Immediately after this offering, our president and chief executive officer, Anthony L. Willsea, will own % of our issued and outstanding common shares. If the underwriters exercise their over-allotment option in full he will own %. In either event, Mr. Willsea has the ability to exercise substantial control over our affairs and corporate actions requiring shareholder approval, including the election of directors, a sale of substantially all of our assets, a merger with another entity or an amendment to our certificate of incorporation. Mr. Willsea's ownership position could delay, deter or prevent a change in control and could adversely affect the price that investors might be willing to pay in the future for our common shares. The initial public offering price of our common shares does not necessarily relate to any established criteria of value so our common shares may trade below the initial public offering price. The initial public offering price per share in this offering has been determined through negotiations between representatives of the underwriters and us and does not necessarily relate to any established criteria of value. We cannot assure you that the trading price of our common shares after this offering will equal or exceed the initial public offering price. An active trading market for our common shares may not develop after this offering and you may be unable to sell your shares. There is currently no public market for our common shares. We cannot assure that an active public trading market for our common shares will develop or be sustained after this offering. If an active and liquid trading market does not develop or is not sustained, you may have difficulty selling your shares. The future sale or availability for sale of substantial amounts of our shares could cause the share price to decline. Sales of a substantial number of our common shares after this offering, or the public perception that these sales may occur, could cause the market price of our common shares to decline and could materially impair our ability to raise capital through the sale of additional equity securities. Upon completion of this offering, we will have ____________ common shares outstanding (____________ if the option we granted to the underwriters to purchase additional common shares from us is exercised in full). In addition, we have reserved ____________ common shares for issuance under our 1998 stock option plan, all of which are covered by options granted before the date of this prospectus and ____________ common shares are reserved for issuance under our 2000 stock plan, of which ____________ common shares are covered by options granted on or before the date of this prospectus. Finally, ___________ common shares are issuable upon exercise of warrants issuable to the representatives of the underwriter in connection with this offering. The ______________ common shares sold in this offering (____________if the option we granted to the underwriters to purchase additional common shares from us is exercised in full), other than shares held by an "affiliate" (as that term is defined by the rules and regulations issued under the Securities Act), will be freely transferable without restriction under the Securities Act. The __________ common shares held by existing shareholders are "restricted securities" as that term is defined in Rule 144 under the Securities Act. These shares may be sold in the future without registration only as permitted by Rule 144 or Rule 701 under the Securities Act or another exemption from registration. In connection with this offering, we, our executive officers and directors and all of our existing shareholders have agreed not to sell any common shares for 180 days after this offering without the consent of the representatives of the underwriters. However, these shares may be released from these restrictions by the representatives of the underwriters at any time. The effect that sales in the public market of shares held by principal shareholders or other shareholders or the potential availability for future sale of these shares will have on their market price is unpredictable. Our management has broad discretion over the use of proceeds from this offering. We currently have identified specific uses for only a small portion of the net proceeds of this offering. Our management has significant flexibility as to the timing and the use of the proceeds. Accordingly, investors in this offering will be relying on management's judgement with only limited information about our specific intentions regarding the use of proceeds. We may spend most of the net proceeds of this offering in ways with which you may not agree. If we fail to apply these funds effectively, our business, results of operations and financial condition may be materially adversely affected. You will experience immediate and substantial dilution. If you purchase common shares in this offering, you will pay more for your shares than existing shareholders paid for their shares. In fact, you will experience immediate and substantial dilution of approximately $___ per share, representing the difference between our book value per share after giving effect to this offering and the initial public offering price. In addition, you may experience further dilution to the extent that common shares are issued upon the exercise of existing stock options at exercise prices less than the initial public offering price per share. As of the date of this offering, we have granted options to our employees and contractors to purchase common shares at prices ranging from $ to $ per share. Furthermore, any additional capital raised through the sale of equity or equity-linked securities would dilute your ownership percentage in us. These securities could also have rights, preferences or privileges senior to those of the common shares. Our certificate of incorporation and bylaws, as well as provisions of the New York Business Corporation Law could deter takeover attempts that may offer you a premium, which could adversely affect our share price. Provisions of our certificate of incorporation, our bylaws and New York law make acquiring control of us without the support of our board of directors difficult for a third party, even if the change of control would be beneficial to our shareholders. The existence of these provisions may deprive you of an opportunity to sell your shares at a premium over prevailing prices. The potential inability of our shareholders to obtain a control premium could adversely affect the market price for our common shares. For example, our certificate of incorporation provides that the board of directors will be divided into three classes as nearly equal in size as possible with staggered three-year terms. This classification of the board of directors has the effect of making it more difficult for shareholders to change the composition of the board of directors. In addition, our certificate of incorporation authorizes our board of directors to issue up to five million "blank check" preferred shares. This means that, without shareholder approval, the board of directors has the authority to attach special rights to preferred shares, including voting and dividend rights. With these rights, preferred shareholders could make it more difficult for a third party to acquire our company. A special meeting of shareholders may only be called by a majority of the board of directors or by our president, chief executive officer or chairman. In addition, a shareholder proposal for an annual meeting must be received within a specified period of time to be placed on the agenda. Because shareholders do not have the ability to require the calling of a special meeting of shareholders and are subject to timing requirements in submitting stockholder proposals for consideration at an annual meeting, any third-party takeover not supported by the board of directors would be subject to significant delays and difficulties.

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+RISK FACTORS You should consider carefully the following risks in addition to the other information in this prospectus before making an investment in the common stock and the notes offered by the selling security holders. Our leverage limits our flexibility and increases our risk of default. Our high degree of leverage could have important consequences to you, such as: - making it more difficult for us to satisfy our obligations with respect to our debt; - limiting our flexibility in planning for, or reacting to, changes in our business and the industries in which we compete and increasing our vulnerability to general adverse economic and industry conditions; - limiting our ability to obtain in the future additional financing we may need to fund future working capital, capital expenditures, product development, acquisitions or other corporate requirements; - requiring the dedication of a substantial portion of our cash flow from operations to the payment of principal of and interest on our debts. This will reduce the availability of cash flow to fund working capital, capital expenditures, product development, acquisitions or other corporate requirements; and - placing us at a competitive disadvantage compared to competitors who are less leveraged and have greater financial and other resources. In addition, the financing documents to which we are a party contain financial and other restrictive covenants. Our failure to comply with these covenants may result in an event of default. If we do not cure or have waived the event of default, we may suffer adverse effects on our operations, business or financial conditions. As of March 25, 2000 we had total indebtedness of $106.6 million, of which $16.8 million consisted of indebtedness under our revolving credit and term loan agreement and $89.9 million consisted of our notes, and stockholders' equity of approximately $45.5 million. See "Management's Discussion and Analysis of Financial Condition and Results of Operations --Liquidity." Our ability to meet our debt obligations and to reduce our indebtedness, including the notes and our revolving credit and term loan agreement, will depend on our future performance. Our performance, to a certain extent, is subject to general economic conditions and financial, business and other factors that are beyond our control. Based upon the current level of operations and related assets currently owned by us and the reduction in our indebtedness as a result of the consummation of the amended joint plan of reorganization, we believe that our current cash reserves and cash flow from operations will be adequate to meet our anticipated requirements for working capital, cash interest payments, scheduled principal payments and general corporate or other purposes through fiscal year 2000. We cannot assure you, however, that we will continue to generate cash flow from operations at or above current levels, that we will be able to meet our cash interest payments on all of our debt or that the related assets currently owned by us can be sustained in the future. If we are unable to generate cash flow from operations in the future to service the notes, the revolving credit and term loan agreement or other future debt, we may try to refinance all or a portion of our debt. We cannot assure you that we will be able to generate sufficient cash flow to pay the interest on our debt or that future borrowings will be available to pay or refinance our debt. Our ability to refinance all or a portion of our debt or to obtain additional financing will be substantially limited under the terms of the notes indenture and the revolving credit and term loan agreement. We cannot assure you that we will not continue to experience net losses or that our net losses will not increase. We had net losses before fresh-start valuation and extraordinary item of approximately $43.1 million in fiscal year 1999, $128.6 million in fiscal year 1998 and $49.7 million in fiscal year 1997. Our management is continuing to pursue a strategy that it began in 1998. We are changing our mix of products to emphasize our most profitable products, while phasing out unprofitable products. Our strategy has enabled our company to pursue the broader strategy of building a leading family entertainment company that creates, publishes and licenses children's entertainment products. We intend to build on our position as a leader in the children's publishing market, using the strength of our brand to provide family-oriented content through many media. Our return to profitability is dependent in part on the successful implementation of management's strategy. We cannot assure you that our strategy will be successful, that we will not continue to experience net losses or that our net losses will not increase. Our recent bankruptcy has had a negative impact on our business in the past and may negatively affect our ability to obtain new business in the future. We emerged from bankruptcy on January 27, 2000, the effective date of our amended joint plan of reorganization. Our experience in and recent emergence from bankruptcy may adversely affect our ability to negotiate favorable terms with manufacturers and other vendors. Our experience in bankruptcy may also adversely affect our ability to obtain new purchase orders from current and prospective customers. The failure to obtain favorable terms from suppliers or new business from current or prospective customers may have adverse effects on our operations, business or financial conditions. Our business may be significantly affected by the loss of our key personnel. We believe that our future success will depend on the abilities and continued service of our executive officers and other key employees. In particular, this means Richard E. Snyder, who serves as Chairman of the Board and Chief Executive Officer of Golden Books, Philip Galanes, who serves as Executive Vice President, Chief Administrative Officer, General Counsel and Secretary of Golden Books, Colin Finkelstein, who serves as Executive Vice President and Chief Financial Officer of Golden Books, and Richard Collins, who serves as Executive Vice President and Chief Operating Officer of Golden Books. We may be unable to retain the services of our executive officers and other key employees. We believe the loss of any executive officers or employees may have a material adverse effect on our business. See "Executive Compensation --Employment Agreements and Change of Control Arrangements." Our business may be significantly affected by the loss of any of our key customers and licensors. The loss of the sales to any of our largest customers would cause a substantial decrease in business and would adversely affect our business. Additionally, we believe that the variety and popularity of characters (whether licensed or owned) are among the most important factors that differentiate our products from those of our competitors. The loss of any principal license can adversely affect our business. In addition, our loss of a significant license will impair our distribution capabilities which, in turn, may adversely affect our ability to obtain new licenses and to renew existing licenses on favorable terms, if at all. Our current amended license agreement with Buena Vista Books, Inc. d/b/a Disney Licensed Publishing ("Disney") will not be renewed and will expire on December 31, 2000. Under the terms of that agreement, commencing on the expiration date, we will have a 13 month period, expiring January 31, 2002, in which we can continue to sell Disney licensed products manufactured by us. In fiscal year 1999, the sales of Disney licensed product accounted for slightly less than 20% of our net sales. We do not believe that the expiration of the amended license agreement with Disney will have a negative impact in fiscal year 2000. However, we cannot assure you that there will not be any long term negative impact on our business due to the expiration of this agreement. See "Business -- Consumer Products." Our relationships with a number of our significant customers and licensors have been contentious from time to time because of disputes, in the case of our customers, relating to prior pricing, return and merchandising policies and, in the case of our licensors, alleged non-compliance by us with certain license terms. While our management has taken steps to repair these relationships, we cannot assure you that these relationships, or other relationships with customers and/or licensors, will not again become contentious in the future, which may adversely affect our business. We operate in a highly competitive industry which may adversely affect our operations. We operate in the children's publishing market which is highly competitive. We believe competition is based primarily on price, quality, distribution, marketing and licenses. In mass market sales, we face competition primarily from smaller competitors. In the trade and specialty trade categories, our principal competitors are large publishing companies. We also compete for a share of consumer spending on children's entertainment and education products against companies that market a broad range of products utilizing a broad range of technologies that are unrelated to those marketed by us. The market for licenses also is highly competitive and we compete against many other licensees for significant licenses. We believe that in recent years, licensors have fragmented licenses, which has reduced the cost of purchasing a license. As a result, smaller bidders have been able to enter the market for licenses, which has resulted in increased competition in this market. Many of our significant competitors have financial resources and, in selected markets, experience substantially greater than us. We are subject to consumer taste. We believe the value of the materials in our library, both to us as a licensor and as an end user, is subject to consumer taste. We cannot assure you that these properties will be attractive to third-party licensees or that they will be suitable for inclusion in our products. If properties that are being exploited cease to be attractive to third-party licensees, our licensing revenue from these licenses will decrease. Intellectual property claims against us can be costly and result in the loss of significant rights. Other parties may assert claims of ownership or infringement or assert a right to payment with respect to the exploitation of these intellectual properties against us. In many cases, the rights owned or being acquired by us are limited in scope, do not extend to exploitation in all present or future media or in perpetuity and may not include the right to create derivative works, such as merchandising and character rights, remakes or sequels. We cannot assure you that we will prevail in any of these claim. In addition, our ability to demonstrate, maintain or enforce these rights may be difficult. The inability to demonstrate or difficulty in demonstrating our ownership or license rights in these properties may adversely affect our ability to generate revenue from or use of these properties. We can not assure you that an active market will develop for the common stock or the notes. The common stock and notes have recently been issued and we cannot assure you that an active market will develop, or, if such a market develops, that this market will be liquid. The common stock is currently quoted on the OTC Bulletin Board. While there are currently nine market makers in Golden Books common stock, none of these market makers are obligated to continue to make a market in Golden Books common stock. In this event, the liquidity of Golden Books common stock could be adversely impacted and a stockholder could have difficulty obtaining accurate stock quotes. The notes are not currently listed on any national securities exchange. Accordingly, we cannot assure you that a holder of the notes will be able to sell these notes in the future or as to the price at which this sale may occur. The liquidity of the market for the notes and the prices at which these notes trade will depend upon the amount outstanding, the number of holders of the notes, the interest of securities dealers in maintaining a market in these notes and other factors beyond our control. The liquidity of, and trading market for, the notes also may be adversely affected by general declines in the market for high yield securities. These declines may adversely affect the liquidity and trading markets for the notes. We have not paid dividends on the Golden Books common stock. Golden Books has never paid a cash dividend on its common stock and the terms of the notes indenture and the revolving credit and term loan agreement restrict the ability of Golden Books to pay dividends on its common stock. We may not be able to finance a change of control offer. Upon the occurrence of certain kinds of change of control events, we will be required to offer to repurchase all of the outstanding notes. However, it is possible that we will not have sufficient funds at the time of the change of control to make the required repurchase of these notes.

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+RISK FACTORS You should carefully consider the risks described below together with all of the other information included in this prospectus before making an investment decision. If any of the following risks actually occurs, our business, financial condition or results of operations could be harmed. In such an event, the trading price of our common stock could decline, and you may lose all or part of your investment. RISKS RELATED TO OUR BUSINESS WE RECENTLY HAVE ACQUIRED SEVERAL BUSINESSES AND FACE RISKS ASSOCIATED WITH INTEGRATING THESE BUSINESSES AND POTENTIAL FUTURE ACQUISITIONS. We recently completed the acquisitions of Axys Advanced Technologies (AAT), Discovery Technologies and 75% of the stock of Structural Proteomics, and are in the process of integrating these businesses. We plan to continue to review potential acquisition candidates in the ordinary course of our business and our strategy includes building our business through acquisitions. Acquisitions involve numerous risks, including among others, difficulties and expenses incurred in the consummation of acquisitions and assimilation of the operations, personnel and services or products of the acquired companies, difficulties of operating new businesses, the diversion of management's attention from other business concerns and the potential loss of key employees of the acquired company. For example, distance and cultural differences may make it difficult for us to successfully assimilate the operations of our recently acquired assay development and high throughout screening operations (Discovery Technologies) located in Switzerland with our medicinal chemistry operations located in San Diego. Further, integrating the chemistry operations performed by AAT with our existing chemistry operations will cause some key employees to have overlapping functional roles, which may lead to their departure if they are unable or unwilling to assume new or different roles within our merged organization. If we do not successfully integrate the three businesses we recently acquired or any businesses we may acquire in the future, our business will suffer. Additionally, acquisition candidates may not be available in the future or may not be available on terms and conditions acceptable to us. Acquisitions of foreign companies also may involve additional risks of assimilating different business practices, overcoming language and cultural barriers and foreign currency translation. We currently have no agreements or commitments with respect to any acquisition and we may never successfully complete any additional acquisitions. WE MAY NOT ACHIEVE OR SUSTAIN PROFITABILITY IN THE FUTURE. We are at an early stage of executing our business plan. We have incurred operating and net losses and negative cash flow from operations since our inception. As of March 31, 2000, we had an accumulated deficit of $21.4 million. For the years ended December 31, 1997, 1998 and 1999 and the three months ended March 31, 2000, we had net losses of $4.8 million, $6.3 million, $3.4 million, and $1.6 million, respectively. We may also in the future incur operating and net losses and negative cash flow from operations, due in part to anticipated increases in expenses for research and product development, acquisitions of complementary businesses and technologies and expansion of our sales and marketing capabilities. We incurred no goodwill charges in the years ended 1997, 1998 and 1999. We incurred goodwill charges in the amount of $155,000 for the three months ended March 31, 2000. Beginning in 2001, goodwill charges for acquisitions we have already made will be $4.2 million per year for the next ten years. Given our acquisition strategy, we expect significant goodwill charges to affect our net income (loss) for the foreseeable future. We may not be able to achieve or maintain profitability. Moreover, if we do achieve profitability, the level of any profitability cannot be predicted and may vary significantly from quarter to quarter. WE MAY INCUR EXCHANGE LOSSES WHEN FOREIGN CURRENCY USED IN INTERNATIONAL TRANSACTIONS IS CONVERTED INTO U.S. DOLLARS. For the three months ending March 31, 2000, 12% of our actual revenue was invoiced and our corresponding expenses were incurred in foreign currency, including the British pound, the Swiss franc and the Euro. Currency fluctuations between the U.S. dollar and the currencies in which we do business will cause foreign currency translation gains and losses. We cannot predict the effects of exchange rate fluctuations on our future operating results because of the number of currencies involved, changes in the percentage of our revenue which will be invoiced in foreign currencies, the variability of currency exposure and the potential volatility of currency exchange rates. We do not currently engage in foreign exchange hedging transactions to manage our foreign currency exposure. IF OUR PRODUCTS AND SERVICES DO NOT BECOME WIDELY USED IN THE PHARMACEUTICAL AND BIOTECHNOLOGY INDUSTRIES, IT IS UNLIKELY THAT WE WILL BE PROFITABLE. We have a limited history of offering our products and services, including our NanoKan System, informatics tools and collections of chemical compounds. It is uncertain whether our current customers will continue to use these products and services or whether new customers will use these products and services. In order to be successful, our products and services must meet the requirements of the pharmaceutical and biotechnology industries, and we must convince potential customers to use our products and services instead of competing technologies. Market acceptance will depend on many factors, including our ability to: - convince potential customers that our technologies are attractive alternatives to other technologies for drug discovery; - manufacture products and conduct services in sufficient quantities with acceptable quality and at an acceptable cost; - convince potential customers to purchase drug discovery products and services from us rather than developing them internally; and - place and service sufficient quantities of our products. Because of these and other factors, our products and services may not gain market acceptance. WE MAY FAIL TO EXPAND CUSTOMER RELATIONSHIPS THROUGH INTEGRATION OF PRODUCTS AND SERVICES. We may not be successful in selling our offerings in combination across the range of drug discovery disciplines we serve because integrated combinations of our products and services may not achieve time and cost efficiencies for our customers. In addition, we may not succeed in further integrating our offerings. We may not be able to use existing relationships with customers in individual areas of our business to sell products and services in multiple areas of drug discovery. If we do not achieve integration of our products and services, we may not be able to take advantage of potential revenue opportunities. OUR SUCCESS WILL DEPEND ON OUR ABILITY TO MANAGE RAPID GROWTH AND EXPANSION. Growth in our operations has placed and, if we grow in the future, will continue to place a significant strain on our operational, human and financial resources. We recently have acquired three new businesses and we intend to continue to grow our business. We have not expanded our management and infrastructure in advance of anticipated growth, nor do we intend to. Therefore, as we expand our operations we will not necessarily have in place infrastructure and personnel sufficient to accommodate the increased size of our business. Our ability to manage effectively any growth through acquisitions or any internal growth will depend, in large part, on our ability to hire, train and assimilate additional management, professional, scientific and technical personnel and our ability to expand, improve and effectively use our operating, management, marketing and financial systems to accommodate our expanded operations. These tasks are made more difficult as we acquire businesses in geographically disparate locations, such as our recent acquisitions of Discovery Technologies in Switzerland, AAT in the San Francisco area, and Structural Proteomics in New Jersey. OUR DIRECTED SORTING PRODUCTS AND OUR LARGE COMPOUND LIBRARIES HAVE LENGTHY SALES CYCLES, WHICH COULD CAUSE OUR OPERATING RESULTS TO FLUCTUATE SIGNIFICANTLY FROM QUARTER TO QUARTER. Sales of our Directed Sorting products and our large compound libraries typically involve significant technical evaluation and commitment of capital by our customers. Accordingly, the sales cycles, or the time from finding a prospective customer through closing the sale, associated with these products, range from six to eighteen months. Sales of these products are subject to a number of significant risks, including customers' budgetary constraints and internal acceptance reviews that are beyond our control. Due to these lengthy and unpredictable sales cycles, our operating results could fluctuate significantly from quarter to quarter. We expect to continue to experience significant fluctuations in quarterly operating results due to a variety of factors, such as general and industry specific economic conditions which may affect the research and development expenditures of pharmaceutical and biotechnology companies. A large portion of our expenses, including expenses for facilities, equipment and personnel, are relatively fixed. Accordingly, if revenues decline or do not grow as anticipated, we might not be able to correspondingly reduce our operating expenses. Failure to achieve anticipated levels of revenues could therefore significantly harm our operating results for a particular fiscal period. Due to the possibility of fluctuations in our revenues and expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. WE DEPEND ON THIRD-PARTY PRODUCTS AND SERVICES AND SOLE OR LIMITED SOURCES OF SUPPLY TO MANUFACTURE SOME COMPONENTS OF OUR DIRECTED SORTING PRODUCTS. We rely on outside vendors to manufacture components and subassemblies used in our Directed Sorting products. Some of these components and subassemblies are obtained from a single supplier or a limited group of suppliers. We depend on sole-source suppliers for the mesh component of our reactors, the radio frequency (RF) tags used in our commercial products and the two-dimensional bar code tags used in our NanoKan System. These materials are obtained from suppliers on standard commercial terms, and we do not have long-term supply agreements with any of these suppliers. Our reliance on outside vendors generally, and a sole or limited group of suppliers in particular, involves several risks, including: - the inability to obtain an adequate supply of required components due to manufacturing capacity constraints, a discontinuance of a product by a third-party manufacturer or other supply constraints; - reduced control over quality and pricing of components; and - delays and long lead times in receiving materials from vendors. WE HAVE NOT YET DELIVERED OUR NANOKAN SYSTEM; ALSO, WE FACE RESTRICTIONS ON OUR ABILITY TO SELL THIS PRODUCT TO ADDITIONAL CUSTOMERS. We have not yet delivered our NanoKan System which we currently are developing for sale to Bristol-Myers Squibb and Aventis. We may not be able to successfully complete development of the NanoKan System and, after development, it may not meet our customers' expectations. Further, under agreements with Bristol-Myers Squibb and Aventis, we are prohibited from delivering the NanoKan System to any additional customers until one year following the delivery of both systems to Bristol-Myers Squibb and Aventis. We expect to deliver both systems in 2000; however, delivery may be delayed beyond 2000 due to factors beyond our control, such as unexpected development problems or natural disasters. If delivery to Bristol-Myers Squibb or Aventis is delayed, we will not be able to deliver additional NanoKan Systems for a longer period of time and therefore, potential revenues for future sales may be delayed or lost. OUR CUSTOMERS MAY RESTRICT OUR USE OF SCIENTIFIC INFORMATION, WHICH COULD PREVENT US FROM USING THIS INFORMATION FOR ADDITIONAL REVENUE. We plan to generate and use information that is not proprietary to our customers and that we derive from performing drug discovery services for our customers. However, our customers may not allow us to use information such as the general interaction between types of chemistries and types of drug targets that we generate when performing drug discovery services for them. Our current contracts restrict our use of scientific information we generate for our customers, such as the biological activity of chemical compounds with respect to drug targets, and future contracts also may restrict our use of scientific information. To the extent that our use of information is restricted, we may not be able to collect and aggregate scientific data and take advantage of potential revenue opportunities. OUR OPERATIONS COULD BE INTERRUPTED BY DAMAGE TO OUR FACILITIES. Our results of operations are dependent upon the continued use of our highly specialized laboratories and equipment. Our operations are primarily concentrated in facilities in San Diego, California and near San Francisco, California and Basel, Switzerland. Natural disasters, such as earthquakes, could damage our laboratories or equipment and these events may materially interrupt our business. We maintain business interruption insurance to cover lost revenues caused by such occurrences. However, this insurance would not compensate us for the loss of opportunity and potential adverse impact on relations with existing customers created by an inability to meet our customers' needs in a timely manner. RISKS RELATED TO OPERATING IN OUR INDUSTRY THE CONCENTRATION OF THE PHARMACEUTICAL INDUSTRY AND THE CURRENT TREND TOWARD INCREASING CONSOLIDATION COULD HURT OUR BUSINESS PROSPECTS. The market for our products and services is highly concentrated, with approximately 50 large pharmaceutical companies conducting drug discovery research. The continuation of the current trend toward consolidation of the pharmaceutical industry may reduce the number of our potential customers even further. Accordingly, we expect that a relatively small number of customers will account for a substantial portion of our revenues. Before our recent acquisitions of AAT, Discovery Technologies and Structural Proteomics, in 1999 our net revenue from our three largest customers represented approximately 22%, 20% and 7% of total net revenue, respectively. Additional risks associated with a highly concentrated customer base include: - fewer customers for our products and services; - larger companies may develop in-house technology and expertise rather than using our products and services; - larger customers may negotiate price discounts or other terms for our products and services that are unfavorable to us; and - the market for our products and services may become saturated. For example, because of the heavy concentration of the pharmaceutical industry and the high cost of our NanoKan System, we expect to sell only a small number of NanoKan Systems before we saturate the market for this product. When we are no longer able to sell additional NanoKan Systems, we will be dependent upon the sale of consumables for revenue from this product line. Similarly, there are signs that the market for our AutoSort System is becoming saturated. THE DRUG DISCOVERY INDUSTRY IS COMPETITIVE AND SUBJECT TO TECHNOLOGICAL CHANGE, AND WE MAY NOT HAVE THE RESOURCES NECESSARY TO COMPETE SUCCESSFULLY. We compete with companies in the United States and abroad that engage in the development and production of drug discovery products and services. These competitors include companies engaged in the following areas of drug discovery: - Assay, development and screening, including Aurora Biosciences and Pharmacopeia; - Combinatorial chemistry instruments, including Argonaut and Bohdan; - Compound libraries and lead optimization, including Albany Molecular Research and Arqule; and - Informatics, including MSI division of Pharmacopeia and Tripos. Academic institutions, governmental agencies and other research organizations also conduct research in areas in which we provide services, either on their own or through collaborative efforts. Also, essentially all of our pharmaceutical company customers have internal departments which provide some of the products and services which we sell, so these customers may have limited needs for our products and services. Even after this offering, many of our competitors including Pharmacopeia will have access to greater financial, technical, research, marketing, sales, distribution, service and other resources than we do. Moreover, the pharmaceutical and biotechnology industries are characterized by continuous technological innovation. We anticipate that we will face increased competition in the future as new companies enter the market and our competitors make advanced technologies available. Technological advances or entirely different approaches that we or one or more of our competitors develop may render our products, services and expertise obsolete or uneconomical. For example, advances in informatics and virtual screening may render some of our technologies, such as our large compound libraries, obsolete. Additionally, the existing approaches of our competitors or new approaches or technologies that our competitors develop may be more effective than those we develop. We may not be able to compete successfully with existing or future competitors. OUR SUCCESS WILL DEPEND ON THE PROSPECTS OF THE PHARMACEUTICAL AND BIOTECHNOLOGY INDUSTRIES AND THE EXTENT TO WHICH THESE INDUSTRIES USE THIRD-PARTY ASSISTANCE WITH ONE OR MORE ASPECTS OF THEIR DRUG DISCOVERY PROCESS. Our revenues depend to a large extent on research and development expenditures by the pharmaceutical, biotechnology and agricultural industries and companies in these industries outsourcing research and development projects. These expenditures are based on a wide variety of factors, including the resources available for purchasing research equipment, the spending priorities among various types of research and policies regarding expenditures during recessionary periods. General economic downturns in our customers' industries or any decrease in research and development expenditures could harm our operations. Any decrease in drug discovery spending by pharmaceutical and biotechnology companies could cause our revenues to decline and adversely impact our profitability. OUR SUCCESS WILL DEPEND ON OUR ABILITY TO ATTRACT AND RETAIN KEY EXECUTIVES, AND EXPERIENCED SCIENTISTS AND SALES PERSONNEL. Our future success will depend to a significant extent on our ability to attract, retain and motivate highly skilled scientists and sales personnel. In addition, our business would be significantly harmed if we lost the services of Riccardo Pigliucci, our chief executive officer, or David Coffen, our chief scientific officer. Our ability to maintain, expand or renew existing engagements with our customers, enter into new engagements and provide additional services to our existing customers depends, in large part, on our ability to hire and retain scientists with the skills necessary to keep pace with continuing changes in drug discovery technologies and sales personnel who are highly motivated. Additionally, it is difficult for us to find qualified sales personnel in light of the fact that our sales personnel generally hold Ph.D's. Our employees are "at will" which means that they may resign at any time, and we may dismiss them at any time. We believe that there is a shortage of, and significant competition for, scientists with the skills and experience in the sciences necessary to perform the services we offer. We compete with pharmaceutical companies, biotechnology companies, combinatorial chemistry companies, contract research companies and academic institutions for new personnel. In addition, our inability to hire additional qualified personnel may require an increase in the workload for both existing and new personnel. We may not be successful in attracting new scientists or sales personnel or in retaining or motivating our existing personnel. THE INTELLECTUAL PROPERTY RIGHTS WE RELY ON TO PROTECT THE TECHNOLOGY UNDERLYING OUR PRODUCTS AND TECHNIQUES MAY NOT BE ADEQUATE, WHICH COULD ENABLE THIRD PARTIES TO USE OUR TECHNOLOGY OR VERY SIMILAR TECHNOLOGY AND COULD REDUCE OUR ABILITY TO COMPETE IN THE MARKET. Our success will depend on our ability to obtain, protect and enforce patents on our technology and to protect our trade secrets. We also depend, in part, on patent rights that third parties license to us. Any patents we own or license may not afford meaningful protection for our technology and products. Others may challenge our patents or the patents of our licensors and, as a result, these patents could be narrowed, invalidated or rendered unenforceable. In addition, current and future patent applications on which we depend may not result in the issuance of patents in the United States or foreign countries. Competitors may develop products similar to ours which are not covered by our patents. Further, since there is a substantial backlog of patent applications at the U.S. Patent and Trademark Office, the approval or rejection of our or our competitors' patent applications may take several years. In addition to patent protection, we also rely on copyright protection, trade secrets, know-how, continuing technological innovation and licensing opportunities. In an effort to maintain the confidentiality and ownership of our trade secrets and proprietary information, we require our employees, consultants and advisors to execute confidentiality and proprietary information agreements. However, these agreements may not provide us with adequate protection against improper use or disclosure of confidential information and there may not be adequate remedies in the event of unauthorized use or disclosure. Furthermore, like many technology companies, we may from time to time hire scientific personnel formerly employed by other companies involved in one or more areas similar to the activities conducted by us. In some situations, our confidentiality and proprietary information agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants or advisors have prior employment or consulting relationships. Although we require our employees and consultants to maintain the confidentiality of all confidential information of previous employers, their prior affiliations may subject us or these individuals to allegations of trade secret misappropriation or other similar claims. Finally, others may independently develop substantially equivalent proprietary information and techniques, or otherwise gain access to our trade secrets. Our failure to protect our proprietary information and techniques may inhibit or limit our ability to exclude certain competitors from the market. THE DRUG DISCOVERY INDUSTRY HAS A HISTORY OF INTELLECTUAL PROPERTY LITIGATION AND WE MAY BE INVOLVED IN INTELLECTUAL PROPERTY LAWSUITS, WHICH MAY BE EXPENSIVE. In order to protect or enforce our patent rights, we may have to initiate legal proceedings against third parties. In addition, others may sue us for infringing their intellectual property rights or we may find it necessary to initiate a lawsuit seeking a declaration from a court that we are not infringing the proprietary rights of others. The patent positions of pharmaceutical, biotechnology and drug discovery companies are generally uncertain. A number of pharmaceutical companies, biotechnology companies, independent researchers, universities and research institutions may have filed patent applications or may have been granted patents that cover technologies similar to the technologies owned by, or licensed to, us or our collaborators. For instance, a number of patents may have been issued or may be issued in the future that could cover certain aspects of our technology that could prevent us from using technology that we use or expect to use. In addition, we are unable to determine all of the patents or patent applications that may materially affect our ability to make, use or sell any potential products. Legal proceedings relating to intellectual property would be expensive, take significant time and divert management's attention from other business concerns, no matter whether we win or lose. The cost of such litigation could affect our profitability. Further, an unfavorable judgment in an infringement lawsuit brought against us, in addition to any damages we might have to pay, could require us to stop the infringing activity or obtain a license. Any required license may not be available to us on acceptable terms, or at all. In addition, some licenses may be nonexclusive, and therefore, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license or are unable to design around a patent, we may be unable to sell some of our products or services. WE MAY BE SUBJECT TO LIABILITY REGARDING HAZARDOUS MATERIALS. Our products and services as well as our research and development processes involve the controlled use of hazardous materials. For example, we sometimes use acids, bases, oxidants, and flammable materials. Acids include trifluoroacetic acid and hydrochloric acid, bases include sodium hydroxide and triethylamine, oxidants include peracids and potassium permanganate, and flammable solvents include methanol, hexane and tetrahydrofuran. We are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of such materials and certain waste products. We cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for any damages that result, and any such liability could exceed our resources and disrupt our business. In addition, we may have to incur significant costs to comply with environmental laws and regulations related to the handling or disposal of such materials or waste products in the future, which would require us to spend substantial amounts of money. RISKS RELATED TO THIS OFFERING OUR STOCK PRICE LIKELY WILL BE VOLATILE, AND YOUR INVESTMENT COULD DECLINE IN VALUE. The trading price of our common stock likely will be volatile and could be subject to fluctuations in price in response to various factors, many of which are beyond our control, including: - actual or anticipated variations in quarterly operating results; - announcements of technological innovations by us or our competitors; - new products or services introduced or announced by us or our competitors; - changes in financial estimates by securities analysts; - conditions or trends in the pharmaceutical and biotechnology industries; - announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments; - additions or departures of key personnel; - economic and political factors; and - sales of our common stock. Negotiations between us and representatives of the underwriters will determine the initial public offering price of our stock based upon a number of factors. This price may not be indicative of prices that will prevail in the trading market, and you may not be able to sell your shares at or above the initial offering price. In addition, price and volume fluctuations in the stock market in general, and the Nasdaq National Market and the market for technology companies in particular, have often been unrelated or disproportionate to the operating performance of those companies. Further, the market prices of securities of life sciences companies have been particularly volatile. Conditions or trends in the pharmaceutical and biotechnology industries generally may cause further volatility in the trading price of our common stock, because the market may incorrectly perceive us as a pharmaceutical or biotechnology company. These broad market and industry factors may harm the market price of our common stock, regardless of our operating performance. In the past, plaintiffs have often instituted securities class action litigation following periods of volatility in the market price of a company's securities. A securities class action suit against us could result in potential liabilities, substantial costs and the diversion of management's attention and resources, regardless of whether we win or lose. THERE MAY NOT BE AN ACTIVE, LIQUID TRADING MARKET FOR OUR COMMON STOCK. There may not be an active trading market for our common stock following this offering. You may not be able to sell your shares quickly or at the market price if trading in our stock is not active. OUR EXECUTIVE OFFICERS, DIRECTORS AND PRINCIPAL STOCKHOLDERS OWN A LARGE PERCENTAGE OF OUR VOTING STOCK AND COULD DELAY OR PREVENT A CHANGE IN OUR CORPORATE CONTROL OR OTHER MATTERS REQUIRING STOCKHOLDER APPROVAL, EVEN IF FAVORED BY OUR OTHER STOCKHOLDERS. Immediately after this offering, our executive officers, directors and principal stockholders, and their respective affiliates, will beneficially own approximately 65.4% of our outstanding common stock. These stockholders, if acting together, would be able to control substantially all matters requiring approval by our stockholders, including the election of all directors and approval of significant corporate transactions. We have agreed to include, as director nominees, a number of nominees of Axys Pharmaceuticals, Inc. which is proportionate to Axys' percentage ownership of our shares. Immediately following this offering, Axys Pharmaceuticals, Inc. will have the right to nominate for election two of seven directors as more fully described on page 61. Axys Pharmaceuticals, Inc., which immediately after this offering will own approximately 33% of our common stock, has agreed to vote all of its stock in favor of management's annual slates of director nominees. FUTURE SALES OF OUR COMMON STOCK MAY DEPRESS OUR STOCK PRICE. The market price of our common stock could decline as a result of sales of substantial amounts of our common stock in the public market after the closing of this offering, or the perception that these sales could occur. In addition, these factors could make it more difficult for us to raise funds through future offerings of common stock. There will be 22,437,204 shares of common stock outstanding immediately after this offering, or 23,187,204 shares if the underwriters exercise their over-allotment option in full, based on the number of shares outstanding at May 5, 2000. All of the shares sold in the offering will be freely transferable without restriction or further registration under the Securities Act, except for any shares that our "affiliates," as defined in Rule 144 of the Securities Act, purchase. The remaining 17,437,204 shares of common stock outstanding will be "restricted securities" as defined in Rule 144, of which 8,465,000 shares will be available for sale, subject to Rule 144, immediately following the expiration of the 180 day lock-up period. These shares may be sold in the future without registration under the Securities Act to the extent permitted by Rule 144 or other exemptions under the Securities Act. After this offering, we intend to register approximately 3,300,000 shares of common stock which our Board of Directors reserved for issuance upon exercise of options granted or reserved for grant under our stock option plans. Once we register these shares, they can be sold in the public market upon issuance, subject to restrictions under the securities laws applicable to resales by affiliates. YOU WILL EXPERIENCE IMMEDIATE AND SUBSTANTIAL DILUTION. We expect the initial public offering price of our common stock to be substantially higher than the net tangible book value per share of our common stock. Therefore, if you purchase shares of our common stock in this offering, you will incur immediate and substantial dilution of approximately $11.60 in the pro forma net tangible book value per share of common stock from the price per share that you pay for the common stock (based upon an assumed initial public offering price of $16.00 per share). If the holders of outstanding options or warrants exercise those options or warrants at prices below the initial public offering price, you will incur further dilution. BECAUSE IT IS UNLIKELY THAT WE WILL PAY DIVIDENDS, YOU WILL ONLY BE ABLE TO BENEFIT FROM HOLDING OUR STOCK IF THE STOCK PRICE APPRECIATES. We have never paid cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future. ANTI-TAKEOVER PROVISIONS IN OUR CHARTER AND BYLAWS COULD MAKE A THIRD-PARTY ACQUISITION OF US DIFFICULT. Our certificate 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 stockholders. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. See "Description of Securities -- Anti-takeover effects of provisions of the certificate of incorporation and bylaws."

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+RISK FACTORS AN INVESTMENT IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISKS AND ALL OTHER INFORMATION CONTAINED IN THIS PROSPECTUS BEFORE YOU DECIDE TO BUY OUR COMMON STOCK. ANY OF THE FOLLOWING RISKS, AS WELL AS OTHER RISKS AND UNCERTAINTIES THAT WE HAVE NOT YET IDENTIFIED OR THAT WE BELIEVE ARE IMMATERIAL, COULD IMPAIR OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CAUSE THE TRADING PRICE OF OUR COMMON STOCK TO DECLINE, AND RESULT IN A PARTIAL OR COMPLETE LOSS OF YOUR INVESTMENT. RISKS RELATED TO OUR BUSINESS WE HAVE SUFFERED LOSSES FOR THE LAST SEVERAL YEARS AND EXPECT LOSSES AND NEGATIVE CASH FLOW TO CONTINUE FOR THE FORESEEABLE FUTURE. We have not been profitable since the year ended February 28, 1993. We incurred net losses of approximately $9.0 million for fiscal 1999, $5.7 million for fiscal 1998 and $9.3 million for fiscal 1997. As of January 30, 2000, we had an accumulated deficit of approximately $34.9 million. We expect operating losses and negative cash flows to continue for the foreseeable future as we continue to incur significant operating expenses and make capital investments. We also expect to significantly increase expenditures for marketing and advertising related to our Internet/Direct operations and to upgrade our technology infrastructure and call, distribution and fulfillment facilities. As a result, we will need to generate significant revenues to achieve and, if achieved, to maintain profitability, which may never occur. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. In addition, we may be unable to adjust our spending quickly enough to offset any unexpected revenue shortfall. If we have a shortfall in revenue in relation to our expenses, our operating results will suffer and our losses and negative cash flow will increase. It is possible that our future results of operations may be below the expectations of securities and other market analysts and investors, which could cause the trading price of our common stock to fall. IF OUR INTERNET/DIRECT GROWTH STRATEGY DOES NOT SUCCEED, OUR BUSINESS AND FINANCIAL CONDITION WILL BE HARMED. Our growth strategy depends in substantial part on our ability to significantly increase sales of our products through our Internet/Direct operations. In order for our Internet/Direct operations to succeed, we must, among other things: - make significant investments in our Internet/Direct operations, infrastructure, and call, distribution and fulfillment facilities in Wichita, Kansas; - significantly increase our online traffic and sales volume; - attract and retain a loyal base of frequent visitors to our Web site; - expand the products we offer over our Web site; - form and maintain relationships with strategic online partners; - provide high-quality customer service; and - continue to develop and upgrade our technologies. We may not be successful in achieving these and other objectives necessary for our Internet/Direct strategy to succeed. If we are not successful in achieving these objectives, our Internet/Direct operations may not be profitable and our results of operations will suffer. IF WE ARE NOT SUCCESSFUL IN MANAGING OUR EXPANSION, OUR BUSINESS WILL BE HARMED. We have no significant experience marketing our products in stores other than in metropolitan New York City, Washington, D.C., Charlotte, North Carolina, Kansas City, Kansas and St. Helena, California, and limited experience managing geographically diverse operations. In addition, our sophisticated gourmet and specialty foods products may not be accepted in other areas. If we fail to adequately adjust our business plans to account for differences in regional preferences, we may not attract the customers we need to successfully expand our retail business. We are also in the process of expanding our call center and distribution and fulfillment facilities and operations. If we fail to complete this expansion as planned, we may not be able to successfully grow our Internet/Direct operations. A successful expansion of our overall business is also dependent upon our ability to establish and maintain adequate management and information systems and financial controls. In this regard, we have commenced consolidating our financial reporting functions from New York, Atlanta and Wichita to Wichita, and this consolidation is expected to be completed by the end of fiscal 2000. If this consolidation takes longer than expected or is otherwise unsuccessful, our ability to expand our operations could be harmed. In addition, this consolidation could be disruptive to our operations and, even if this consolidation is successful, we may have difficulties during this period relating to tracking inventory, billing and collecting, and accurately and timely maintaining our financial records. In addition, we have recently replaced our management information systems, including purchasing, accounting and inventory management, and our accounting software, at a cost of $650,000. If we are unable to successfully integrate these systems or if we fail to continue to maintain or upgrade these systems, our business and results of operations could be harmed. In addition, we intend to replace our point-of-sale technology. If the replacement or integration of our new system is not successful, our business or financial results will be harmed. OUR OPERATING RESULTS WILL SUFFER IF SALES DURING OUR PEAK SEASONS DO NOT MEET OUR EXPECTATIONS. Our results of operations have fluctuated from quarter-to-quarter as a result of, among other things, increased business during the holiday season. Historically, we have realized the majority of our revenues in the third and fourth quarters. Due to our recent change in fiscal year end, we anticipate that we will realize in the future the majority of our revenues in the fourth fiscal quarter. Accordingly, any decline in our sales in the fourth quarter will adversely impact our results of operations in the applicable year. You should not rely on quarter-to-quarter comparisons of our results of operations contained elsewhere in this prospectus as an indication of our future performance. In anticipation of increased sales activity during the holiday season, we have historically hired a significant number of temporary employees to supplement our permanent staff and significantly increased our inventory levels. If sales during the holiday season do not meet our expectations, we may not generate sufficient revenue to offset these increased costs and our operating results will suffer. IF WE FAIL TO CONTINUE TO DEVELOP AND MAINTAIN OUR BRAND, WE WILL LOSE CUSTOMERS AND OUR REVENUES WILL DECLINE. We must continue to develop and maintain the Dean & DeLuca brand in order to maintain and expand our customer base and revenues. We believe that the importance of brand recognition will increase as we expand our Internet/Direct operations. We intend to substantially increase our expenditures in order to create and maintain brand loyalty as well as raise awareness of our brand. If we fail to advertise and market our products effectively, we may not succeed in maintaining and developing our brand in the future and our business will suffer. Our success in promoting and enhancing the Dean & DeLuca brand will also depend on our success in providing our customers with high-quality products and a high level of customer service. If our customers do not perceive our products and services to be of high-quality, the value of our brand will be diminished. OUR PLANNED MARKETING CAMPAIGNS FOR OUR INTERNET/DIRECT OPERATIONS MAY FAIL OR MAY DETRACT FROM OUR IMAGE. We plan to use a significant portion of the proceeds of this offering to pursue marketing and advertising campaigns online and in print media in order to promote the Dean & DeLuca brand, and to attract an increasing number of catalogue shoppers and visitors to our Web site. This investment in increased marketing and advertising carries with it significant risks, including the following: - Our advertisements may not properly convey the Dean & DeLuca brand image and may even detract from our image. - Unlike online advertising, which gives us immediate feedback and allows us to promptly adjust our messages, advertising in print media is less flexible. Advertisement in print media typically takes longer and costs more to produce and consequently have longer run times. If we fail to convey the optimal message in these advertising campaigns, the impact may be lasting and very costly to correct. - Even if we succeed in creating the right messages for our promotional campaigns, these advertisements may fail to attract new customers for our Internet/Direct operations at levels commensurate with their costs. We also may fail to choose the optimal mix of print and other media to cost-effectively deliver our message. If our currently planned marketing efforts are unsuccessful, we will face difficult and costly choices in deciding whether and how to redirect our marketing expenditures. OUR BUSINESS AND GROWTH STRATEGIES WILL REQUIRE ADDITIONAL CAPITAL, WHICH WE MAY NOT BE ABLE TO RAISE ON TERMS SATISFACTORY TO US, IF AT ALL. Our business and growth strategies will require additional capital, including our plans to: - increase our marketing and advertising expenditures to promote our Internet/Direct operations; - increase the number of our retail stores; - introduce new products; and - continue investing in our infrastructure. We cannot be certain that funds required to implement our strategies will be available to us on terms satisfactory to us when needed, if at all. We may borrow funds under agreements with covenants that would limit our ability to borrow additional capital as needed in the future or impose other limitations on the operation of our business. If funds are not available when needed or are not available on acceptable terms, we will not be successful in implementing our strategies. To the extent that we raise additional equity capital, it would have a dilutive effect on our existing stockholders. WE DEPEND ON A SMALL NUMBER OF STORES FOR A LARGE PORTION OF OUR REVENUES. Five specialty markets, seven cafes and a wine store accounted for approximately 85.3% of our revenues for fiscal 1999. Poor financial performance at any one of these stores, especially our flagship market in New York City which generated 32.9% of our total retail revenues for fiscal 1999, would hurt our overall profitability. Also, all of our retail stores are leased under agreements expiring during the next two to 12 years. Our failure to renew any one of these lease agreements upon its expiration could hurt our business and results of operations. Due to our small number of markets and cafes and their locations, adverse publicity relating to an individual store may affect our sales substantially more than if our markets and cafes were more broadly dispersed. The results achieved to date by our relatively small markets and cafes base may not be indicative of the results of a large number of markets and cafes in a more geographically dispersed area with varied local characteristics. Because of our relatively small market and cafe base, an unsuccessful new market or cafe could have a more significant effect on our financial performance than would be the case if we operated more markets and cafes. WE MAY FAIL TO OPEN NEW SPECIALTY MARKETS AND CAFES. We may not be able to open new specialty markets and cafes as currently planned or otherwise. Our ability to do so will depend upon a number of factors, many of which are beyond our control, including our ability to: - select and secure suitable sites; - negotiate acceptable lease terms for new sites; - secure required governmental permits and approvals; - coordinate and manage operations in multiple and perhaps geographically distant and diverse locations; and - generate funds from operations or obtain adequate financing from third parties on favorable terms or at all. Our failure to open additional stores as planned will significantly and negatively impact our retail expansion plans. NEW SPECIALTY MARKETS AND CAFES MAY NOT SUCCEED. We currently plan to open one or two specialty markets during calendar 2001 and three or four specialty markets in each of the five years thereafter. We will also consider opening three or four cafes near each of our new specialty markets after a market has been in business for about a year. Our proposed expansion will require the implementation of enhanced operational and financial systems as well as additional management, operational and financial resources. Failure to implement these systems or to have these resources would likely restrict us from opening new markets and cafes as planned. In addition, if new markets and cafes are opened, our failure to achieve positive results at these markets and cafes would hurt our business. WE DEPEND ON OUR KEY PERSONNEL TO OPERATE OUR BUSINESS. Our performance is dependent on several of our key executives, including Dane J. Neller, our Chief Executive Officer, John B. Richards, our President, Patrick A. Roney, our Senior Vice President--Marketing, George E. Mileusnic, our Executive Vice President and Chief Financial Officer, Duminda M. De Silva, our Senior Vice President--Internet/Direct Operations, and Curtis L. Gray, our Executive Vice President--Retail Division. If any of these individuals leave our employ, we may not be able to find adequate replacements. The loss of any of these individuals or any of our other key employees could harm our ability to continue to develop and manage our business. We do not have employment agreements with our executive officers, except for Mr. Richards. We do not maintain "key person" life insurance that would result in a payment to us in the event of the death of any of our executive officers. SEVERAL KEY MEMBERS OF OUR MANAGEMENT TEAM HAVE ONLY RECENTLY JOINED US AND IF THEY ARE NOT SUCCESSFULLY INTEGRATED INTO OUR BUSINESS OR FAIL TO WORK TOGETHER AS A MANAGEMENT TEAM, OUR BUSINESS WILL SUFFER. Several key members of our management team have joined us since January 30, 2000, including John B. Richards, our President, George E. Mileusnic, our Chief Financial Officer and Executive Vice President, Curtis L. Gray, our Executive Vice President--Retail Division, and James E. Bartlett, our Vice President--Internet/Direct Operations. We also expect to hire additional key personnel. If we do not effectively integrate these employees and new employees into our business, or if they do not work together as a management team to enable us to implement our business strategy successfully, our business will suffer. WE MAY NOT BE ABLE TO HIRE ENOUGH ADDITIONAL MANAGEMENT AND OTHER PERSONNEL AS OUR BUSINESS GROWS. The success of our business depends upon our ability to attract and retain highly motivated, well-qualified management and other personnel, including technical personnel. We face significant competition in the recruitment of qualified employees. Some metropolitan areas we currently serve, and intend to expand into, have competitive labor markets, especially for qualified technical personnel with retail experience. If we are unable to recruit or retain a sufficient number of qualified employees, or if the costs of compensation, or of outsourcing these tasks to third-party providers, or if employee benefits were to increase substantially, our business would suffer. Our employees are not unionized. If they were organized by labor unions, our labor costs could increase, perhaps significantly. IF WE FAIL TO EFFECTIVELY COMPETE WITH OTHER GOURMET AND SPECIALTY FOODS, HIGH PREMIUM WINE AND UPSCALE KITCHENWARE BUSINESSES, WE COULD LOSE CUSTOMERS AND OUR REVENUES COULD DECLINE. The gourmet and specialty foods, high premium wine and upscale kitchenware markets are highly competitive and fragmented and have few barriers to entry. The number of stores and Internet and catalogue businesses with operations generally similar to ours has grown considerably in the last several years, and we believe that competition from these stores and Internet and catalogue businesses is increasing. Many of our competitors or potential competitors have substantially greater financial, marketing and other resources and wider geographical diversity than we do, which may allow them to react to changes in the industry faster and more effectively than us. In addition, we expect the competition to increase in the geographic markets in which we operate. Increased competition could result in: - price reductions, decreased revenues and lower profit margins; - loss of market share; and - increased marketing expenditures. If we fail to compete successfully in these markets, we could lose customers and our revenues could decline. WE DEPEND ON THE CONTINUED OPERATION OF OUR CALL, DISTRIBUTION AND FULFILLMENT CENTER IN WICHITA, KANSAS. We conduct nearly all of our call, distribution and fulfillment operations and our Internet/Direct operations' order processing and fulfillment functions from a single center in Wichita, Kansas. Any disruption in the operations at our Wichita call, distribution and fulfillment center for any reason, including due to damage from fire, natural disaster, power loss, telecommunications failure or similar events, particularly during the holiday shopping season, could cause us to be unable to fulfill Internet/ Direct orders. This failure could cause us to lose customers, would harm our business and would lead to a decline in revenues. We are also dependent on temporary employees to adequately staff our call, distribution and fulfillment center, particularly during busy periods such as the holiday shopping season. We cannot assure you that we will continue to receive adequate assistance from our temporary employees, or that we will continue to be able to hire a sufficient number of temporary employees. Failure to attract adequate temporary employees could harm our business. WE RELY HEAVILY ON THIRD PARTIES FOR OPERATIONS ESSENTIAL TO OUR BUSINESS. We depend on third parties for important aspects of our business, including: - Internet access; - development of software for new Web site features and online customer service; - content of our Web site and catalogues; - product shipping; and - telecommunications. We have limited control over these third parties, and we are not their only client. We may not be able to maintain satisfactory relationships with any of them on acceptable commercial terms. As a result, any disruptions of or failures in services provided by these third parties may impair our ability to deliver goods and services to our customers. Further, we cannot be certain that the quality of products and services that they provide will remain at the levels necessary to enable us to conduct our business effectively. For example, failure to maintain our Web site or our telecommunications service will impair our ability to generate revenues. Our future success depends upon these third party relationships because we rely on third parties to maintain our Web site and our telecommunications service. If we fail to maintain these relationships or to replace them on financially attractive terms, our operations may suffer disruptions and we may incur significant unanticipated costs. Many of our online strategic relationships with third parties are on very favorable terms that provide for revenue sharing. We may not be able to renew these agreements when they expire on similar terms, if at all. If we lose any of our third party relationships and are not able to replace them, we may experience reduced brand exposure as well as a disruption to our growth strategy. We also rely on a number of common carriers to deliver products purchased by our customers through our Internet/Direct operations. These carriers may experience labor stoppages, which could impact our ability to deliver products on a timely basis to our customers and adversely affect our customer relationships. Any reduction in performance, disruption in Internet access or disruption of services provided by third parties could materially adversely affect our business, financial condition and results of operation. OUR CATALOGUE BUSINESS IS SUBJECT TO MANY FACTORS BEYOND OUR CONTROL, INCLUDING FLUCTUATIONS IN THE COST OF POSTAGE AND PAPER AND DELIVERY SERVICES PROVIDED BY THIRD PARTIES, THAT COULD CAUSE OUR REVENUES TO DECLINE AND ALSO CAUSE US TO LOSE CUSTOMERS. Our overall success depends in part on the success of our catalogue operations, which in turn depends on many factors, including the following, some of which are beyond our control: - our ability to achieve adequate response rates to our mailings; - our ability to continue to offer a mix of products that is attractive to our mail-order customers; - general economic conditions; - the timing of our catalogue mailings; - our ability to cost-effectively add new customers; and - our ability to cost-effectively design and produce appealing catalogues. Catalogue production and mailings entail substantial paper, postage, merchandise acquisition and human resource costs, including costs associated with catalogue development and increased inventories. Catalogue production and distribution costs represented approximately 37.1% of our Internet/Direct revenues during fiscal 1999. A substantial portion of these expenses are attributable to paper and postage costs. Material increases in the cost of paper or catalogue delivery could significantly increase our expenses and reduce our profitability. We incur nearly all of the costs associated with our catalogues prior to the mailing of each catalogue. As a result, we are not able to adjust the costs incurred in connection with a particular mailing to reflect the actual performance of the catalogue. If we were to experience a significant shortfall in anticipated revenue from a particular mailing, and thereby not recover the costs associated with that mailing, our results could be adversely affected. We have historically experienced fluctuations in the response rates to our catalogue mailings. If we are unable to accurately target the appropriate segment of the consumer catalogue market or to achieve adequate response rates, we could experience lower sales, significant markdowns or write-offs of inventory, and lower margins. We have established relationships with a number of common carriers for the delivery of our products. If these carriers were to raise the prices they charge to ship our goods, our customers might choose to buy comparable products locally to avoid shipping charges. OUR REVENUES AND INCOME COULD DECLINE DUE TO CHANGES IN CONSUMER PREFERENCES AND PERCEPTIONS OR AN ECONOMIC DOWNTURN. The industry segments in which we operate are often affected by changes in consumer tastes, national, regional and local economic conditions, and demographic trends. Individual store performance and our overall performance generally may be adversely affected by traffic patterns, demographic changes, the cost and availability of labor, our purchasing power, the availability of products, and the type, number and location of our competitors. Our financial success is partially dependent upon economic conditions and consumer attitudes. Purchases of our specialty products are discretionary. Low or negative growth in the economy or volatility or a decline in the financial markets could reduce discretionary spending and, as a result, reduce our sales. IF WE DO NOT ACCURATELY PREDICT CUSTOMER DEMAND FOR OUR PRODUCTS, WE MAY LOSE CUSTOMERS OR EXPERIENCE INCREASED COSTS. We expect that our need to maintain product inventory will become increasingly more important. We intend to increase inventory levels and the number of products maintained in our warehouse in connection with the further development of our Internet/Direct operations. If we do not predict inventory levels accurately or if we overestimate customer demand for our products, excess inventory and outdated merchandise will accumulate, tying up working capital and potentially resulting in reduced warehouse capacity and inventory losses due to spoilage, damage, theft and obsolescence. On the other hand, if we underestimate customer demand, we may disappoint our customers who are seeking unavailable products. Any misjudgment on our part could cause us to lose actual or potential customers and could cause our revenues to decline. Moreover, the strength of our brand could be diminished due to misjudgments about merchandise selection. IF WE FAIL TO PROVIDE OUR CUSTOMERS WITH ADEQUATE CUSTOMER SERVICE, WE MAY NOT GENERATE SUFFICIENT LEVELS OF INITIAL AND REPEAT ORDERS AND MARKET PENETRATION, AND OUR RESULTS OF OPERATIONS COULD BE HARMED. In the online retail industry, customer attrition rates, or the rates at which subscribers cancel a service, are generally high. Although we do not charge a subscription fee for our service, our Internet/ Direct operations do depend upon customers continuing to order from us after they place their initial order. A critical part of our business strategy depends on hiring, training and retaining customer-friendly customer service agents to answer telephone and e-mail inquiries, to offer online customer service and to provide prompt attention and helpful information in response to our customers' concerns. If we fail to provide high-quality customer care, or if we are unable to establish sufficient customer loyalty, we may experience significant decreases in repeat customer orders, and our business could be harmed. Retention of customers is also dependent on operational execution. If orders are incorrect, incomplete or not delivered on time, customer retention rates could decline and, in turn, cause our revenues and profitability to decline. BECAUSE WE HAVE AN UNCONDITIONAL RETURN POLICY, WE MAY BE REQUIRED TO INCUR SUBSTANTIAL COSTS TO ISSUE REFUNDS, CREDITS OR REPLACEMENT PRODUCTS. Our unconditional return policy allows customers who are not satisfied with their online and catalogue purchases to return products purchased from us to our fulfillment centers or to any of our stores. At the customer's option, we either send the customer another product or issue the customer a refund or a credit. Our profitability could decline if a significant number of customers request replacement products, refunds or credits. OUR EARNINGS WILL BE ADVERSELY AFFECTED BECAUSE OF STOCK-BASED COMPENSATION EXPENSES THAT WE HAVE INCURRED AND WILL CONTINUE TO INCUR. During fiscal 1999, we recorded an approximate $25,000 non-cash compensation charge related to sales and grants of common stock and stock options made to employees, directors and consultants. Based principally on sales and grants of common stock and stock options made to date, we will record, and our earnings will be reduced by, a total of approximately $1.9 million of additional non-cash compensation charges through fiscal 2002, which will end on February 2, 2003, as follows: approximately $929,000 for fiscal 2000, which will end on January 28, 2001, approximately $551,000 for fiscal 2001, which will end on February 3, 2002, approximately $286,000 for fiscal 2002, which will end on February 2, 2003, and approximately $118,000 for fiscal 2003, which will end February 1, 2004. RISKS RELATED TO THE INTERNET AND OUR TECHNOLOGY THE SUCCESS OF OUR GROWTH STRATEGY IS SIGNIFICANTLY DEPENDENT ON THE CONTINUED GROWTH IN THE USE OF THE INTERNET AS A COMMERCIAL MEDIUM. If our Internet/Direct operations do not achieve and maintain sufficient customer volume, we may not be able to increase our revenues or achieve profitability. The use of the Internet as a commercial medium is new and evolving rapidly. It is uncertain whether e-commerce will achieve and sustain high levels of demand and market acceptance, particularly for the sale of gourmet and speciality foods, high premium wines and upscale kitchenware. Our success will depend to a substantial extent on the willingness of consumers to increase their use of online service as a means of buying gourmet and specialty foods, high premium wines and upscale kitchenware and other products and resources. Specific factors that could prevent customer acceptance of the Internet as a channel for buying our goods include: - deferred delivery compared to the immediate receipt of products at a traditional store; - customers' desire to see and touch products, particularly fresh produce, prior to purchase; - product selection that is less varied than customers desire; - perceived or actual lack of security or privacy of online transactions; and - difficulties in making accurate and timely deliveries to customers. Moreover, the growth of our business will depend on the growth of the number of consumers who have access to personal computers or other systems that can access the Internet. If e-commerce in the gourmet and specialty foods, high premium wines and upscale kitchenware markets does not achieve high levels of demand and market acceptance, we may not successfully implement our growth strategy and our results of operations will be harmed. THE SUCCESSFUL GROWTH OF THE INTERNET MAY NOT CONTINUE OR BE SUSTAINED. The Internet has experienced, and is expected to continue to experience, substantial growth in the number of users and the amount of traffic, resulting in some cases in substantial delays for users. The Internet could lose its viability due to delays in the development or adoption of new standards and protocols to handle increased levels of Internet activity or due to increased government regulation. Reliable network backbones and secure transaction processing necessary to make e-commerce economically viable may not develop. Even if they are developed, the Internet may not become a viable commercial marketplace for products like ours. If the necessary infrastructure and complementary services are not developed, or if the Internet does not become a viable commercial marketplace for our products, our business could be harmed. Specific factors that could inhibit the continued growth of the Internet include: - inability of the Internet infrastructure to support the demands placed on it; and - decline in the performance and reliability of the Internet as usage increases. In addition, the growth projections of Internet-related activities included in this prospectus are only estimates by industry analysts and may not prove to be accurate. IF WE ARE UNABLE TO ADAPT TO THE RAPID TECHNOLOGICAL CHANGES IN E-COMMERCE, THE FEATURES OFFERED ON OUR WEB SITE COULD BECOME OBSOLETE AND WE COULD LOSE CUSTOMERS AND HARM OUR STRATEGIC RELATIONSHIPS. E-commerce is characterized by rapidly-changing technology. The success of our Internet/Direct operations depends upon our ability to add new features and enhancements to our Web site that keep pace with technological and market developments. Our hardware and software systems will require continuous improvement to meet the demands of our customers. The development of new features and the enhancement of existing services and products entails significant technical efforts and may require substantial unanticipated costs. We may not be successful in: - maintaining and improving our hardware and software; - effectively using new technologies; - adapting our Web site operations to emerging industry standards; or - developing and introducing features and enhancements to our Web site. Failure to succeed in these efforts could delay or prevent the successful marketing of our Internet/ Direct operations. As a result, our Web site operations may not meet the requirements of the marketplace and may not achieve market acceptance. If we are unable, for technical or other reasons, to continuously evolve our Web site to enhance its accessability, content and ease of use or respond to changing market conditions or customer requirements, or if our Web site operations do not achieve market acceptance, we may lose actual or potential customers, harm our brand and our reputation, and lose some or all of our strategic relationships. Further, if our potential or existing customers do not find our catalogue or our Web site a convenient shopping destination, we will not attract or retain customers and our sales will suffer. If our competitors' catalogues or Web sites are perceived as easier-to-use or otherwise better able to satisfy customer needs, our customer traffic could decrease and our business would be harmed. IF WE ARE UNABLE TO AUTOMATE KEY FUNCTIONS AND UPGRADE OUR EXISTING MANAGEMENT INFORMATION SYSTEMS, OUR BRAND MAY BE HARMED AND WE MAY LOSE CUSTOMERS AND HARM OUR STRATEGIC RELATIONSHIPS. We cannot assure you that our existing or new transaction-processing systems and our network infrastructure will be able to accommodate increases, if any, in the volume from our Internet/Direct operations in the future. We also may not be able to accurately predict the rate or timing of these increases or to effectively upgrade our systems and infrastructure to accommodate future growth in our Internet/Direct operations. We also cannot assure you that we will be able in a timely manner to effectively upgrade and expand our transaction-processing systems or to successfully integrate any newly-developed or purchased modules with our existing systems. If we are unable to upgrade our technology, we may suffer from unanticipated system disruptions, slower response times, degradation in levels of customer service, impaired quality and speed of order fulfillment or delays in reporting accurate financial information. A failure to process information properly also may negatively impact or damage our brand. Damage to our brand, fulfillment delays and the failure to cost effectively and efficiently upgrade and expand our current technology would prevent us from attracting and retaining customers, could cause us to lose some or all of our strategic relationships, and consequently harm our business. UNEXPECTED SYSTEM INTERRUPTIONS CAUSED BY SYSTEM FAILURES MAY HARM OUR REPUTATION AND CAUSE OUR REVENUES TO DECREASE. We currently do not have redundant systems or a formal disaster recovery plan in place, and we do not carry sufficient business interruption insurance to compensate us for the losses that may occur. Our servers are vulnerable to computer viruses, physical or electrical break-ins and similar disruptions, which could lead to interruptions, security breaches, delays, loss of data or the inability to accept and confirm customer orders, any of which would harm our reputation and result in reduced revenues. In the past, particularly during peak holiday periods, we have experienced significant increases in traffic on our Web site and in the number of calls to our call center. Our operations are dependent on our ability to maintain our computer and telecommunications systems in effective working order and to protect our systems against damage from fire, natural disaster, power loss, telecommunications failure or similar events. Our systems have experienced in the past, and may experience in the future: - system interruptions; - long response times; and - degradation in our service. Because our business depends on customers making purchases on our systems, our revenues will decrease and our reputation could be harmed if we experience frequent or long system delays or interruptions or if a disruption occurs, especially during a peak holiday season. ANY BREACH OF ONLINE PRIVACY AND SECURITY AND CREDIT CARD FRAUD COULD CAUSE US TO LOSE ACTUAL OR POTENTIAL CUSTOMERS, SERIOUSLY IMPEDE THE GROWTH OF OUR ONLINE BUSINESS, AND SUBJECT US TO POSSIBLE LIABILITY. The secure transmission of confidential information over the Internet is essential in maintaining consumer and supplier confidence in online commerce. Substantial or ongoing security breaches on our Web site or other Internet-based systems could significantly disrupt our business. It is possible that advances in computer capabilities, new discoveries or other developments could result in a compromise or breach of the technology that we use to protect merchant and customer transaction data. We cannot guarantee that security measures taken by us will prevent security breaches. A party that is able to circumvent our current or future security systems could steal proprietary or personal information or cause interruptions in our operations. Security breaches also could damage our reputation and cause us to lose actual and potential customers, as well as expose us to a risk of loss or to litigation and possible liability. Our insurance policies carry low coverage limits, which may not be adequate to reimburse us for losses caused by security breaches. We also face risks associated with security breaches affecting third parties conducting business over the Internet. Any publicized security problems could inhibit the growth of the Internet as a means of conducting commercial transactions and hinder the success of our online operations. Failure to adequately control fraudulent credit card transactions will reduce our sales and our margins because we do not carry insurance against this risk. To date, we have suffered losses as a result of orders placed with fraudulent credit card data even though the associated financial institution approved payment of the orders. Under current credit card practices, we are liable for fraudulent credit card transactions because we do not obtain a cardholder's signature. GOVERNMENT REGULATION AND LEGAL UNCERTAINTIES COULD ADD BURDENS TO OUR DOING BUSINESS ON THE INTERNET, WHICH WOULD HINDER OUR ONLINE OPERATIONS. Online commerce is new and rapidly changing, and federal and state regulations relating to the Internet and online commerce are evolving. Currently, there are few laws or regulations directly applicable to access to the Internet or online commerce. However, laws and regulations applicable to Internet communications, commerce and advertising are becoming more prevalent in the United States and throughout the world. It is possible that laws and regulations may be enacted to address issues such as user privacy, freedom of expression, pricing, content, intellectual property rights, information security, distribution, taxation, advertising, antitrust matters and the quality of products and services. The adoption of these laws or regulations could reduce the rate of growth of the Internet, which could potentially decrease the usage of our Web site and harm our Internet/Direct operations. In addition, the applicability to the Internet of existing laws governing issues such as property ownership, copyrights and other intellectual property issues, libel, obscenity and personal privacy is uncertain. Most of these laws were adopted prior to the advent of the Internet and do not contemplate or address the unique issues of the Internet. New laws applicable to the Internet may impose substantial burdens on companies, including us, that conduct business over the Internet. The growth of e-commerce may prompt calls for more stringent consumer protection laws in the United States and abroad. Several states have proposed legislation to limit the uses of personal user information gathered online or require online services to establish privacy policies. The Federal Trade Commission had also initiated action against at least one online service regarding the manner in which personal information is collected from users and provided to third parties. We do not currently provide personal information regarding our users to third parties. However, the adoption of such consumer protection laws could create uncertainty in Internet usage and reduce the demand for our products and services. Several telecommunications carriers have asked the Federal Communications Commission, or FCC, to regulate telecommunications over the Internet. Due to the increasing use of the Internet and the burden it has placed on the telecommunications infrastructure, telephone carriers have requested the FCC to regulate Internet and online service providers and to impose access fees on those providers. If the FCC imposes access fees, the costs of using the Internet could increase dramatically, which would harm our business. WE MAY BE VULNERABLE TO TAX OBLIGATIONS THAT COULD BE IMPOSED ON OUR INTERNET/DIRECT OPERATIONS. We do not expect to collect sales or other similar taxes in respect of shipments of goods into most states. However, various states or foreign countries may seek to impose sales tax obligations on us and other online commerce and direct marketing companies. States have attempted to impose sales taxes on catalogue sales from businesses such as ours. A successful assertion by one or more states that we should have collected or be collecting sales taxes on the sale of our products through our Internet/ Direct operations could adversely affect us. In 1998, the United States Congress passed the Internet Tax Freedom Act, which places a three-year moratorium on the ability of the states and localities to impose taxes on Internet access, unless such tax was imposed prior to October 1998, and discriminatory taxes on online commerce. Congress may not renew this legislation in 2001. If the legislation is not renewed, state and local governments would be free to impose Internet-specific taxes on electronically purchased goods. We cannot predict the impact of any additional Internet-specific laws or regulations on our business. Any proposal to impose additional taxes on the sale of goods and services through the Internet, if adopted, could cause purchasing through our Web site to be less attractive to customers as compared to traditional retail purchasing and we may not successfully maintain or grow our Internet/ Direct operations. RISKS RELATING TO LEGAL UNCERTAINTIES OUR BUSINESS IS SUBJECT TO VARIOUS GOVERNMENTAL REGULATIONS. Our business is subject to and affected by various federal, state and local laws, including regulations relating to: - alcoholic beverage control; - the preparation and sale of food; - public health and safety; - sanitation; and - building, zoning and fire codes. REGULATION OF SALE OF ALCOHOL. The distribution of wine and other alcoholic beverages is subject to extensive federal, state, county and municipal regulation and taxation relating to: - licensing; - payment of excise taxes; - advertising; - trade and pricing practices; - product labeling; - sales to minors and intoxicated persons; and - relationships among product producers, importers, wholesalers and retailers. Our alcoholic beverage operations are subject to more regulations and higher taxation than our non-alcohol-related business. The alcoholic beverage industry also is subject to considerable societal and political attention associated with the effects of alcohol and the manner of promoting the sale of alcoholic beverages. This attention relates to such matters as the liability of the alcoholic beverage industry for harms caused by individuals who drive while intoxicated, the restriction or prohibition of print and electronic advertising or other promotional activities and the investigation of other marketing or promotion activity which allegedly targets youth as potential consumers of alcoholic beverages. The possibility always exists for further regulation of the wine industry. The effect on our business operations of an increase in regulation or an increase in taxation will depend on the amount of the increase as well as on other factors, but any increase could harm our business. Some jurisdictions require companies to obtain licenses and permits to sell alcohol while others do not allow companies such as ours to sell alcohol in their jurisdictions at all. For example, we are currently prohibited from selling alcohol in the State of Kansas. We cannot assure you that we will be able to obtain any or all required permits or licenses in a timely manner, or at all. We may be forced to incur substantial costs and experience significant delays in obtaining these permits or licenses. In addition, the U.S. Congress is considering enacting legislation that would restrict the interstate sale of alcoholic beverages over the Internet. Changes to existing laws or our inability to obtain required permits or licenses could prevent us from selling premium wines in one or more geographic markets or in a portion of those markets. In those locations where we cannot obtain alcohol permits or licenses, we will be unable to sell premium wines and will lose an opportunity to increase revenue. USDA REGULATION. As of the date of this prospectus, we are not regulated by the U.S. Department of Agriculture, or USDA. Whether the handling of food items in our markets, cafes and fulfillment center, such as meat and fish, will subject us to USDA regulation in the future will depend on several factors, including whether we sell food products on a wholesale basis and whether we obtain food products from non-USDA inspected facilities. In the future, the USDA may require costly changes to our food handling operations. We are also required to comply with local health regulations concerning the preparation and packaging of any prepared food items, such as deli salads that we prepare on-site. Applicable federal, state or local regulations may cause us to incur substantial compliance costs or delay the availability of items at one or more of our markets, cafes or at our call, distribution and fulfillment center, which could harm our business. FAILURE TO OBTAIN NECESSARY APPROVALS. The failure by us to obtain or retain food, liquor or other licenses, permits or approvals would harm our operations. These government regulations impact not only our current operations but also our growth strategy. Difficulties, delays or failure in obtaining licenses, permits or approvals in new locations could delay or impede the growth of our operations. In addition, any inquiry or investigation from a regulatory authority could harm our reputation and any liability claims could require us to spend significant time and money in litigation. THE FOOD SERVICE INDUSTRY IN GENERAL IS AFFECTED BY LITIGATION AND PUBLICITY CONCERNING FOOD QUALITY, HEALTH AND OTHER ISSUES, WHICH CAN CAUSE CUSTOMERS TO AVOID OUR PRODUCTS AND SUBJECT US TO LIABILITIES. Food service businesses can be adversely affected by litigation and complaints from customers or government authorities resulting from food quality, illness, injury or other health concerns or operating issues stemming from one store or a limited number of stores. Adverse publicity about any allegations against our products may negatively affect us and our business, regardless of whether the allegations are true, by discouraging customers from buying our products. A lawsuit or claim could result in a decision against us that could materially adversely affect our business and results of operations. Also, we could incur substantial litigation costs, regardless of the result of the litigation. OUR BUSINESS AND PROSPECTS MAY BE SERIOUSLY HARMED IF WE ARE UNABLE TO ADEQUATELY PROTECT AND ENFORCE OUR INTELLECTUAL PROPERTY RIGHTS. We regard our intellectual property as important to our success and ability to compete and expand. We rely solely on copyright, trade secret, and trademark law and confidentiality agreements with our employees to protect our proprietary rights in our technology, processes, content or other intellectual property to the extent such protection is sought or secured at all. We hold registered trademarks for the "Dean & Deluca," "Dean & Deluca Selections" and "St. Helena Kitchens" names and stylized logos. We require most of our executive-level employees to sign confidentiality agreements; however, we do not require all employees to do so. Other than John B. Richards, our President, none of our employees have a signed proprietary rights agreement or otherwise have agreed to assign to us their proprietary rights in any inventions or other intellectual property created by them during their employment. In addition, to the extent these agreements were entered into after employment commenced and no additional consideration was provided to the employee, a court may decline to enforce some or all of the agreements' terms. Despite these and other efforts to protect our proprietary rights, we cannot guarantee that the steps we take to protect our proprietary rights are adequate to protect against unauthorized uses of our intellectual property or other information that we regard as proprietary. Policing against unauthorized uses is difficult and we may not be able to identify all unauthorized uses of our intellectual property or may fail to take appropriate steps to enforce our proprietary rights. Defending our proprietary rights could result in costly and time-consuming litigation that would divert valuable managerial and financial resources, which could harm our business, financial condition, and results of operations. WE MAY BE LIABLE FOR CONTENT DISPLAYED ON AND COMMUNICATED THROUGH OUR WEB SITE AND ANY SUCH CLAIMS COULD CAUSE SIGNIFICANT EXPENDITURES AND ALSO HARM OUR BRAND AND REPUTATION. We may be sued for defamation, negligence, copyright or trademark infringement or other legal claims relating to product information or other content that we publish or make available on our Web site. These types of claims have been brought against online companies as well as print publications in the past. We may also be sued based on online content that we do not control but that is accessible from our Web site through links that we provide to other Web sites. We could incur substantial expenses and be forced to divert attention from our business operations to defend ourselves against claims such as those, even if frivolous. Any claim against us and any litigation involving us, however frivolous, may be expensive and time consuming to defend and may harm our brand and our reputation. WE MAY NOT BE ABLE TO PROTECT OUR DOMAIN NAME AGAINST ALL INFRINGERS, WHICH COULD DECREASE THE VALUE OF OUR BRAND NAME AND PROPRIETARY RIGHTS. We currently own the Internet domain name "deandeluca.com," as well as various other related names. The acquisition and maintenance of domain names generally is regulated by Internet regulatory bodies. The regulation of domain names in the United States and in foreign countries is subject to change. Regulatory bodies could establish additional top-level domains, appoint additional domain name registrars or modify the requirements for holding domain names. As a result, we may be unable to acquire or maintain domain names in all countries where we conduct or wish to conduct business. The relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we could be unable to prevent third parties from acquiring domain names that infringe or otherwise decrease the value of our brand name, trademarks and other proprietary rights. INTELLECTUAL PROPERTY CLAIMS AGAINST US CAN BE COSTLY TO DEFEND, AND COULD RESULT IN THE LOSS OF SIGNIFICANT RIGHTS AND REQUIRE US TO ENTER INTO ROYALTY LICENSE AGREEMENTS. Many companies are devoting significant resources to develop patents that could affect many aspects of our business. Other parties may assert infringement or unfair competition claims against us that could relate to any aspect of our technologies, business processes or other intellectual property. We cannot predict whether third parties will assert claims of infringement against us, the subject matter of any of these claims, or whether these assertions or prosecutions will harm our business. If we are forced to defend ourselves against any of these claims, whether or not they have merit or are determined in our favor, then we may face costly litigation, diversion of technical and management attention, an inability to use our current Web site technology or product shipment delays. As a result of a dispute, we may have to develop non-infringing technology or enter into royalty or licensing agreements. These royalty or licensing agreements, if required, may be unavailable on terms acceptable to us, or at all. If there is a successful claim of infringement against us and we are unable to develop non-infringing technology or license the infringed or similar technology on a timely basis, our business and competitive positions may be hurt. RISKS RELATED TO THIS OFFERING WE MAY SPEND THE PROCEEDS FROM THIS OFFERING IN WAYS THAT OUR STOCKHOLDERS MAY NOT AGREE. The net proceeds of the sale of our common stock in this offering will be approximately $ million, after deducting underwriting discounts and commissions and estimated offering expenses. Our management will retain broad discretion as to how to spend these proceeds and may spend the proceeds in ways that you may not approve. Although we do not have a specific plan, we intend to use the net proceeds from this offering in general as follows: - to fund the opening of new specialty markets and cafes; - to market and advertise our Internet/Direct operations; - to develop technology, including further design and development of our Web site and the implementation of a fully-integrated management information system; - to expand our call, distribution and fulfillment facilities; - to expand human resources to support both our technology and infrastructure needs; and - for other corporate purposes. The failure of our management to apply these proceeds effectively could harm our business. OUR STOCK PRICE MAY EXPERIENCE EXTREME PRICE AND VOLUME FLUCTUATIONS AND YOU MAY LOSE ALL OR A PART OF YOUR INVESTMENT. The market price of our common stock may fluctuate significantly in response to factors, including the following, most of which are beyond our control: - variations in our quarterly operating results; - changes in market valuations of similar companies; - changes in estimates by securities analysts; - future sales of our securities; - market volatility in general; and - departures of key personnel. Before this offering, there was no public market for our common stock. The price of our common stock after this offering may be lower than the initial public offering price or the price that you pay. An active public market for our common stock may not develop or be sustained after this offering. We negotiated and determined the initial public offering price with the representatives of the underwriters and this price may not be indicative of prices that will prevail in the trading market. As a result, you may be unable to sell your shares of common stock at or above the offering price or the price that you pay, and you may lose some or all of your investment. OUR DIRECTORS AND EXECUTIVE OFFICERS WILL RETAIN SUBSTANTIAL CONTROL OVER US AFTER THIS OFFERING, WHICH MAY LEAD TO CONFLICTS WITH OTHER STOCKHOLDERS OVER CORPORATE GOVERNANCE. After this offering, our directors and executive officers will beneficially own approximately % of our outstanding common stock. Leslie G. Rudd, the Chairman of our board of directors, will own approximately % of our outstanding common stock, and Hummer Winblad Venture Partners IV, L.P. will beneficially own approximately % of our outstanding common stock upon completion of this offering. Accordingly, these stockholders together, or Mr. Rudd individually, are able to exercise substantial control over all matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions, such as mergers or other business combination transactions. This control may delay or prevent a third a party from acquiring us or merging with us, even if doing so might benefit our stockholders. THE SUBSTANTIAL NUMBER OF SHARES THAT WILL BE ELIGIBLE FOR SALE IN THE NEAR FUTURE MAY CAUSE THE MARKET PRICE FOR OUR COMMON STOCK TO DROP SIGNIFICANTLY, EVEN IF OUR BUSINESS IS DOING WELL. Sales of substantial number of shares of our common stock in the public market following this offering could reduce the market price for our common stock. The number of shares of common stock available for sale in the public market is limited by restrictions under federal securities laws and under "lock-up" agreements that our stockholders, executive officers and directors have entered into with the underwriters. These "lock-up" agreements generally restrict our stockholders from selling shares for a period of 180 days after the date of this prospectus, however FleetBoston Robertson Stephens Inc. may waive these restrictions at any time without notice. The following table indicates when the shares of our common stock that were outstanding as of the date of this prospectus will be eligible for sale into the public market, subject to compliance with federal securities laws: <TABLE> <CAPTION> ELIGIBILITY OF SHARES FOR SALE IN PUBLIC MARKET ------------------------- <S> <C> Immediately................................................. At various times during the first 179 days after the date of this prospectus........................................... 108,884 On the 180th day after the date of this prospectus.......... 14,667,907 At various times beginning 181 days after the date of this prospectus................................................ 2,590,969 </TABLE> The shares eligible for sale in the public market at various times beginning 181 days after the date of this prospectus includes 2,600,969 shares of common stock issuable upon exercise of currently outstanding options and warrants. Most of the shares that will be available for sale beginning on the 181st day after the date of this prospectus or afterwards will be subject to volume limitations because they are held by our affiliates. In addition, we cannot assure you that the lock-up restrictions will not be removed prior to 180 days after this offering with the prior consent by the underwriters. For a detailed description of the securities we currently have outstanding and an analysis of when they will be available for sale in the public market place, see "Shares Eligible for Future Sale." INVESTORS IN THIS OFFERING WILL SUFFER IMMEDIATE AND SUBSTANTIAL DILUTION. Investors purchasing shares in this offering will incur immediate and substantial dilution in net tangible book value per share. To the extent outstanding options and warrants to purchase common stock are exercised, there will be further dilution. For a discussion of the dilution new investors will experience, see "Dilution." ANTI-TAKEOVER PROVISIONS IN OUR SECOND RESTATED CERTIFICATE OF INCORPORATION AND BY-LAWS MAY MAKE IT MORE DIFFICULT OR EXPENSIVE TO ACQUIRE US IN THE FUTURE OR MAY CAUSE OUR STOCK PRICE TO DECLINE. Our second restated certificate of incorporation and bylaws contain several provisions, including our classified board of directors, the manner in which our vacancies are filled and provisions relating to the calling of stockholder meetings and stockholder proposals to be determined at those meetings, that may make it more difficult or more expensive for a third party to acquire control of us without the approval of our board of directors. These provisions may also delay, prevent or deter a merger, acquisition, tender offer, proxy contest or other transaction that might otherwise result in our stockholders receiving a premium over the market price for their common stock. Our stock price could also decline because of these provisions. For a detailed discussion of these provisions, see "Description of Capital Stock--Special Provisions in our Second Restated Certificate of Incorporation and By-laws may have Anti-Takeover Effects."

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+RISK FACTORS As a stockholder, you will be subject to all risks inherent in our business. The market value of your shares will reflect the performance of our business relative to, among other things, that of our competitors and general economic, market and industry conditions. The value of your investment may increase or may decline and could result in a loss. You should carefully consider the following factors as well as the other information contained in this prospectus before deciding to invest in our common stock. We depend on attracting and retaining qualified consultants Our success depends upon our ability to attract and retain consultants who possess the skills and experience necessary to fulfill our clients' executive search needs. Competition for qualified consultants is intense. Our ability to attract and retain qualified consultants could be impaired by any diminution of our reputation, decrease in compensation levels or restructuring of our compensation system. In addition, we may not be successful in identifying and hiring consultants with the requisite experience, skills and established client relationships. If we cannot attract and retain qualified consultants, our business, financial condition and results of operations will suffer. We may not be able to prevent our consultants from taking our clients with them to another firm Our success depends upon the ability of our consultants to develop and maintain strong, long-term relationships with our clients. Usually, one or two consultants have primary responsibility for a client relationship. When a consultant leaves one executive search firm and joins another, clients that have established relationships with the departing consultant may move their business to the consultant's new employer. We may also lose clients if the departing consultant has widespread name recognition or a reputation as a specialist in executing searches in a specific industry or management function. Historically, we have not experienced significant problems with this client portability. However, if we fail to prevent our departing consultants from moving business to his or her new employer, our business, financial condition and results of operations will be adversely affected. Our success depends on our ability to maintain our professional reputation and brand name We depend on our overall reputation and brand name recognition to secure new engagements and hire qualified professionals. Our success also depends on the individual reputations of our professionals. We obtain a majority of our new engagements from existing clients or from referral by those clients. Any client who is dissatisfied with our work can adversely affect our ability to secure those new engagements. If any factor hurts our reputation, including poor performance, we may experience difficulties in competing successfully for both new engagements and qualified consultants. Failing to maintain our professional reputation and brand name could seriously harm our business. Our LeadersOnline business has a history of losses Our LeadersOnline business has incurred significant losses. For the nine months ended September 30, 1999, LeadersOnline had an operating loss of $3.8 million. In addition, we expect to devote significant resources to the future development of LeadersOnline. The limited operating history of LeadersOnline makes the prediction of future results of operations difficult and there can be no assurance that LeadersOnline's operating losses will not increase in the future or that LeadersOnline will ever achieve or sustain profitability. In addition, the online recruiting market is new and rapidly evolving, and we do not yet know how effective online recruiting will be compared to traditional recruiting methods. We may lose part or all of our investments made in venture capital funds On December 16, 1999, we announced that we expect to invest up to $25 million in venture capital funds. These funds expect to make investments in start-up companies, primarily in the technology sector. Although we expect to make investments in increments over the next three years, the full investment may be made at any time. These investments are inherently risky and we may lose part or all of our investment. Because our clients may restrict us from recruiting their employees we may be unable to fill existing executive search assignments We frequently refrain from recruiting employees of a client when conducting executive searches on behalf of other clients. We enter into these blocking arrangements with clients by agreement or for marketing and client relationship purposes. These restrictions generally remain in effect for one year following the commencement of an engagement. However, the specific duration and scope of the blocking arrangements depend on the following factors: . the length of the client relationship . the frequency with which the client engages us to perform searches . the number of assignments we have performed for the client . the potential for future business with the client Some of our clients are industry leaders that employ a large number of qualified executives who are potential candidates for other companies in that client's industry. If the clients' competitors discover that we are restricted from recruiting the employees of our clients these competitors may not engage us to perform their executive searches. In addition, as our client base grows, we may be unable to fulfill existing search assignments if this restriction prohibits us from recruiting from our other clients. If we are overly restricted by these blocking arrangements, our business, financial condition and results of operations will suffer. We face aggressive competition The global executive search industry is extremely competitive and highly fragmented. We compete with other large global executive search firms and with smaller specialty firms. Specialty firms can focus on regional or functional markets or on particular industries. Some of our competitors possess greater resources, greater name recognition and longer operating histories than we do in particular markets. Our competitors can use these advantages to obtain future clients and attract qualified professionals in those markets. There are limited barriers to entry into the search industry and new search firms continue to enter the market. Many executive search firms that have a smaller client base may be subject to fewer blocking arrangements than we. We may not be able to continue to compete effectively with existing or potential competitors. In addition, our significant clients or prospective clients may decide to perform executive searches using in-house personnel. We may have difficulty implementing our acquisition strategy Our ability to grow and remain competitive depends on our ability to acquire other executive search firms. Although we continually evaluate possible acquisitions, we may not succeed in identifying and completing these strategic acquisitions. In addition, an acquired business may not achieve desired levels of revenue, profitability or productivity. If any acquired firm performs poorly, we could be adversely affected because of client dissatisfaction. In addition, these acquisitions may involve the following risks: . diversion of management's attention . difficulties in the integration of operations . difficulties in retaining personnel . increased conflict of interest among clients . adverse tax and accounting impacts We may finance future acquisitions with common stock, debt or cash. Our ability to finance acquisitions using common stock is dependent upon the market price of our common stock. We may be unable to accomplish desirable acquisitions because of a drop in the market price of our common stock. Our success depends on our ability to achieve and manage growth We are experiencing and may continue to experience significant growth in our operations and employee base. This growth places significant strains on our administrative, operational and financial resources and may not generate proportionate revenue growth. If we are successful in expanding our business, we must recruit and hire additional consultants and administrative personnel. Our growth will diminish if we fail to attract and retain additional personnel. In addition, we make large initial investments to recruit new consultants. Our average revenue per consultant and overall profitability may suffer in the short term from new hires. If we need to open offices in new geographic locations, we will incur substantial start-up and maintenance costs. To manage our growth successfully, we must continue to improve and upgrade our financial, accounting and information systems. Failure to upgrade our systems could materially adversely affect our business. We rely heavily on information management systems Our success depends upon our ability to store, retrieve, process and manage substantial amounts of information. To achieve our goals, we must continue to improve and upgrade our information management systems. We may be unable to license, design and implement, in a cost-effective manner, improved information systems that allow us to compete effectively. If we experience any interruptions or loss in our information processing capabilities, our business, financial condition and results of operations will suffer. We face the risk of liability in performing executive searches We are exposed to potential claims with respect to the executive search process. A client could assert a claim for violations of blocking arrangements, breaches of confidentiality agreements or malpractice. In addition, a candidate could assert an action against us. Possible claims include failure to maintain the confidentiality of the candidate's employment search or for discrimination or other violations of the employment laws. We maintain professional liability insurance in amounts and coverages as we believe are adequate. However, we cannot guarantee that our insurance will cover all claims and that the coverage will be available at reasonable rates. Our employee stockholders have voting control of our company and, as a result, certain decisions may be made by them that may be detrimental to your interests Our employee stockholders are, and will continue to be, after the offering beneficial owners of a majority of our common stock. These employee stockholders will have sufficient voting power to elect the entire Board of Directors and cause or prevent any change of control. Without consent of the other stockholders, these employee stockholders can determine the outcome of any corporate transaction, including a merger, a consolidation, or a sale of any or all of our assets. Our multinational operations may be adversely affected by social, political and economic risks We generated revenues outside the United States of 39.8%, for the nine months ended September 30, 1999, and 44.2%, for the year ended December 31, 1998. We offer our services in 33 countries from 69 locations around the world. We are exposed to the risk of changes in social, political and economic conditions inherent in foreign operations. In particular, we conduct business in countries where the legal systems and trade practices are evolving. Commercial laws in these countries are often vague, arbitrary and inconsistently applied. Under these circumstances, it is difficult for us to determine at all times the exact requirements of such local laws. If we fail to comply with local laws, our business, financial condition and results of operations will suffer. In addition, the global nature of our operations poses challenges to our management, financial systems and accounting systems. Failure to meet these challenges could seriously harm our business. We have antitakeover provisions that make an acquisition of us more difficult and expensive Antitakeover provisions in our Certificate of Incorporation, our Bylaws and the Delaware laws make the acquisition of us in a transaction not approved by our board of directors more difficult or expensive. Some of the provisions in our Certificate of Incorporation and Bylaws include: . a classified board of directors . limitations on the removal of directors . limitations of stockholder actions . advance notification procedures for director nominations and actions to be taken at stockholder meetings . the authorization to issue one or more series of preferred stock with specific voting rights and other powers These provisions could discourage an acquisition attempt or other transaction in which stockholders receive a premium over the current market price for the common stock. The net proceeds from this offering may be allocated in ways with which you may not agree Our management has significant flexibility in applying the net proceeds we receive in this offering. Because the net proceeds are not required to be allocated to any specific investment or transaction, you cannot determine at this time the value or propriety of our management's application of the proceeds and you and other shareholders may not agree with our decisions. Failure of management to apply the proceeds effectively could have a material adverse effect on our business. Our stock price continues to be volatile We have been a public company with shares selling on the Nasdaq National Market for less than one year. Although a market has developed for our shares, we cannot guarantee that this market will be sustained after the completion of this offering. The market price of our common stock may be significantly affected by the following factors: . results of operations . changes in any earnings estimate published by securities analysts . developments affecting us, our clients or our competitors . factors affecting the executive search industry . conditions of the financial markets and economy in general In addition, the stock market has experienced a high level of price and volume volatility. The volatility of a company's stock price may not necessarily be related to the operating performance of a company. We cannot guarantee that the market price for our common stock will be stable. The recent increase in our stock price may negatively impact our earnings per share Our stock price increased significantly during the last quarter of 1999. Because we report fully diluted earnings per share using the treasury method, the significant increase in our stock price will require us to report a greater number of shares outstanding on a fully diluted basis than forecasted. Such reporting could negatively impact the fully diluted earnings per share we report for our fiscal year ending December 31, 1999, and may cause our reported fully diluted earnings per share to be lower than estimates published by certain financial analysts. We do not anticipate paying dividends We intend to retain all of our earnings for the future operation and expansion of our business. We do not anticipate paying cash dividends on our common stock at any time in the foreseeable future. Shares eligible for future sale may adversely affect our stock price Prior to this offering there were 16,663,151 shares of common stock issued and outstanding. Of these shares, there are approximately 11.3 million shares which may not be sold in the absence of registration under the Securities Act or an exemption from the Securities Act. In addition, there are currently 1,509,275 shares of common stock issuable pursuant to stock options and restricted stock units which have been granted under our employee incentive plans. Upon issuance, these shares will be freely tradeable by persons other than our affiliates, without restriction under the Securities Act. When the shares which are not freely tradeable are eligible for future sale in the public market, these sales or the perception of these sales could adversely affect the market price of our common stock. The future sales of these shares could also impair our ability to raise additional capital through the sale of equity securities. We have agreed, for a period of 90 days after the date of this prospectus, not to offer, sell or dispose of any shares without prior written consent of Lehman Brothers Inc. other than shares of common stock issued in the offering, under our employee incentive plans or upon exercise of stock options granted pursuant to employee incentive plans. Additionally, in our initial public offering, all of our then current employees agreed for a period of two years from April 27, 1999, not to offer, sell, or dispose of any of their shares without prior written consent of Lehman Brothers Inc. except for shares and options issued under our employee incentive plans or shares acquired in the open market after completion of this offering. Our multinational operations may be adversely affected by the European Monetary Union Starting January 1, 1999, eleven European countries entered into the European Monetary Union and introduced the Euro as a common currency. During a three- year transition period, the national currencies will continue to circulate, but their relative values will be fixed denominations of the Euro. We recognize that there are risks and uncertainties associated with the conversion to the Euro. These risks and uncertainties include: . an increasingly competitive European environment resulting from greater transparency of pricing . inability to update financial reporting systems on a timely basis We have upgraded our systems to enable us to process transactions denominated in Euro. Further system upgrades will be adopted between now and December 2000 in preparation for full implementation of the single European currency in 2002. Failure to adapt information technology systems could have an adverse effect on our financial condition and results of operations. We are also dependent on many third parties, including banks and providers of information. If any of these systems are not appropriately upgraded to manage transactions denominated in Euro, our operations will suffer. CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS This prospectus includes "forward-looking statements" for purposes of the Securities Act of 1933 and the Securities Act of 1934. All statements other than statements of historical fact in this prospectus, including statements regarding our competitive strengths, business strategy, future financial position, projected costs and plans and objectives of management are forward- looking statements. Forward-looking statements generally can be identified by the use of forward-looking terminology such as "may", "will", "expect", "should", "intend", "estimate", "anticipate", "believe", "continue" or similar terminology. Although we believe that the expectations reflected in any such forward-looking statements are reasonable, we can give no assurance that these expectations will prove to be correct. Important factors that could cause actual results to differ materially from our expectations are disclosed under "Risk Factors" and elsewhere in this prospectus and expressly qualify all written and oral forward-looking statements attributable to us.

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+RISK FACTORS You should carefully consider the risks described below and other information in this prospectus before making any decision to invest in our common stock. If any of the following risks actually occurs, our business, financial condition or operating results could be materially adversely affected. In this case, the trading price of our common stock could decline, and you could lose all or part of your investment. Risks Related to Our Business Cyclical Industry If Our Industry Were To Experience A Downturn In The Business Cycle, Our Revenues Could Be Adversely Affected. The semiconductor industry is highly cyclical and is generally characterized by average selling price fluctuations. Since the fourth quarter of 1997, we have experienced significant declines in the pricing of our products as customers reduced demand and manufacturers reduced prices to avoid a significant decline in capacity utilization. We believe these pricing declines were due primarily to the Asian economic crisis and excess semiconductor manufacturing capacity. Although the semiconductor market has recently improved, we cannot assure you that these improvements are sustainable or will continue or that the semiconductor market will not experience subsequent, and possibly more severe and/or prolonged, downturns in the future. We cannot assure you that any future downturn in the semiconductor market will not have a material adverse effect on our revenues. Short-Term Performance Fluctuations In Our Quarterly Operating Results May Cause Our Stock Price To Decline. Given the nature of the markets in which we participate, we cannot reliably predict future revenues and profitability, and unexpected changes may cause us to adjust our operations. A high proportion of our costs are fixed, due in part to our significant sales, research and development and manufacturing costs. Thus, small declines in revenue could disproportionately affect our operating results in a quarter. Factors that could affect our quarterly operating results include: the timing and size of orders from our customers, including cancellations and reschedulings; the timing of introduction of new products; the gain or loss of significant customers, including as a result of industry consolidation; seasonality in some of our target markets; changes in the mix of products we sell; changes in demand by the end users of our customers products; market acceptance of our current and future products; variability of our customers product life cycles; changes in manufacturing yields or other factors affecting the cost of goods sold, such as the cost and availability of raw materials and the extent of utilization of manufacturing capacity; changes in the prices of our products, which can be affected by the level of our customers and end users demand, technological change, product obsolescence or other factors; and cancellations, changes or delays of deliveries to us by our third-party manufacturers, including as a result of the availability of manufacturing capacity and the proposed terms of manufacturing arrangements. New Product Development And Technological Change An Inability To Introduce New Products Could Adversely Affect Us, And Changing Technologies Or Consumption Patterns Could Reduce The Demand For Our Products. Rapidly changing technologies and industry standards, along with frequent new product introductions, characterize the industries that are currently the primary end-users of semiconductors. As these industries evolve and introduce new products, our success will depend on our ability to adapt to such changes in a timely Table of Contents and cost-effective manner by designing, developing, manufacturing, marketing and providing customer support for our own new products and technologies. We cannot assure you that we will be able to identify changes in the product markets of our customers and end-users and adapt to such changes in a timely and cost-effective manner. Nor can we assure you that products or technologies that may be developed in the future by our competitors and others will not render our products or technologies obsolete or noncompetitive. A fundamental shift in technologies or consumption patterns in our existing product markets or the product markets of our customers or end users could have a material adverse effect on our business or prospects. Competition Competition In Our Industry Could Prevent Us From Maintaining Our Level Of Revenues And From Raising Prices To Reflect Increases In Costs. The semiconductor industry, particularly the market for semiconductor components, is highly competitive. Although only a few companies compete with us in all of our product lines, we face significant competition within each of our product lines from major international semiconductor companies as well as smaller companies focused on specific market niches. Many of these competitors have substantially greater financial and other resources than we have with which to pursue development, engineering, manufacturing, marketing and distribution of their products and are better able than we are to withstand adverse economic or market conditions. In addition, companies not currently in direct competition with us may introduce competing products in the future. Significant competitors in the discrete market include International Rectifier, Philips, Rohm, Siliconix, ST Microelectronics and Toshiba. Significant competitors in the standard analog markets include Analog Devices, Fairchild, Linear Technology, Maxim Integrated Products, National Semiconductor, ST Microelectronics and Texas Instruments. Significant competitors in the standard logic product market include Fairchild, Hitachi, Philips, Texas Instruments and Toshiba. The semiconductor components industry has also been undergoing significant restructuring and consolidations that could adversely affect our competitiveness. Because our components are often building block semiconductors that in some cases can be integrated into more complex integrated circuits, we also face competition from manufacturers of integrated circuits, application-specific integrated circuits and fully customized integrated circuits, as well as customers who develop their own integrated circuit products. We compete in different product lines to various degrees on the basis of price, quality, technical performance, product features, product system compatibility, customized design, availability, delivery timing and reliability and sales and technical support. Gross margins in the industry vary by geographic region depending on local demand for the products in which semiconductors are used, such as personal computers, industrial and telecommunications equipment, consumer electronics and automotive goods. In regions where there is a strong demand for such products, price pressures may also emerge as competitors attempt to gain a greater market share by lowering prices. Our ability to compete successfully depends on elements both within and outside of our control, including industry and general economic trends. Manufacturing Risks Unless We Maintain Manufacturing Efficiency And Avoid Manufacturing Difficulties, Our Future Profitability Could Be Adversely Affected. Manufacturing semiconductor components involves highly complex processes that require advanced and costly equipment. We and our competitors continuously modify these processes in an effort to improve yields and product performance. Impurities or other difficulties in the manufacturing process can lower yields. Our manufacturing efficiency will be an important factor in our future profitability, and we cannot assure you that we will be able to maintain our manufacturing efficiency or increase manufacturing efficiency to the same extent as our competitors. From time to time we have experienced difficulty in beginning production at new facilities or in effecting transitions to new manufacturing processes that have caused us to suffer delays in product deliveries or reduced yields. We cannot assure you that we will not experience manufacturing problems in achieving acceptable yields or experience product delivery delays in the future as a result of, among other things, capacity constraints, construction delays, upgrading or expanding existing facilities or changing our process Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any state where the offer or sale is not permitted. PROSPECTUS (Subject to Completion) Issued April 25, 2000 30,000,000 Shares [ON SEMICONDUCTOR LOGO] SCG Holding Corporation COMMON STOCK Table of Contents technologies, any of which could result in a loss of future revenues. Our results of operations could also be adversely affected by the increase in fixed costs and operating expenses related to increases in production capacity if revenues do not increase proportionately. Lack Of Independent Identity We Have Recently Established A Trade Name Identity Independent Of Motorola. A Failure To Establish The Same Level Of Goodwill As Motorola Could Harm Our Long-Term Business Prospects. Our future success and competitive position depend, in part, on our ability to establish goodwill in our products and services and to associate that goodwill with our trade name, ON Semiconductor . In order for us to establish goodwill, customers must acknowledge the quality of our products and services and associate our trade name with that quality and those products and services. Prior to our recapitalization, all of the products and services we offered were sold, distributed and advertised under the Motorola trade name. Consequently, the goodwill of the Motorola trade name may have been associated, in part, with success of those products and services. We have begun marketing our products under the ON Semiconductor name. However, for one year after our recapitalization, an agreement we have with Motorola gives us the limited ability to use the Motorola trade name in connection with the sale, distribution and advertisement of some products we offer. We are presently using our best efforts to cease using licensed Motorola trademarks as soon as commercially reasonable. If the removal of the Motorola trade name from any of our products would require the product to be requalified by any of our customers, we may continue to use the Motorola trade name for up to two years after our recapitalization, to allow us to continue selling the product pending its requalification. In addition, for two years after our recapitalization, we also have the ability to utilize the transition statement, formerly a division of Motorola, in connection with the sale, distribution and advertisement of some products we offer. The impact of our no longer using the Motorola trade name cannot be fully predicted and it could have a material adverse effect on our business or our prospects. Although we have recently established our trade name and brands independent of Motorola, we cannot assure you that, prior to the expiration of these transitional arrangements, we will have established the same level of goodwill in our trade name as Motorola has established in its trade name. Lack Of Independent Operating History If The Assumptions We Have Used To Estimate Future Operating Results Are Incorrect Or If We Encounter Unexpected Costs Or Other Problems, Our Profitability Could Be Adversely Affected. Prior to our recapitalization, Motorola allocated to us, as one of several divisions within its Semiconductor Products Sector, a percentage of the expenses related to services Motorola provided to us and other divisions of its Semiconductor Products Sector. During 1998, we incurred approximately $298 million in costs for general, administrative, selling and marketing expenses, of which Motorola allocated to us approximately $119 million for services shared with other divisions of its Semiconductor Products Sector. As part of our recapitalization, we identified the specific services that we believed were necessary to our business and that we would not be able initially to provide ourselves. Motorola agreed to provide or arrange for the provision of these services, including information technology, human resources, supply management and finance services, for a limited period of time to facilitate our transition to a stand-alone company. We estimate that we will incur not more than $75 million under these arrangements for general, administrative, selling and marketing related expenses during the first year after our recapitalization and that our aggregate general, administrative, selling and marketing expenses during that period will be less than those directly charged and allocated in 1998. In addition, Motorola agreed to continue to provide worldwide shipping and freight services to us for a period of up to three years after our recapitalization using the cost allocation method Motorola previously used with us. Under this arrangement, we anticipate paying Motorola approximately $30 million in the first year following our recapitalization. We believe that the scope of the agreements we entered into with Motorola as part of our recapitalization and the time frames, pricing and other terms should provide us sufficient time to effect our transition to a stand-alone company with minimal disruption to our business, and that we will ultimately be able to provide SCG Holding Corporation is offering 30,000,000 shares of its common stock. This is our initial public offering and no public market currently exists for our shares. We anticipate that the initial public offering price will be between $15 and $17 per share. Table of Contents these services ourselves or identify third-party suppliers to provide such services on terms not materially less favorable to us than the terms of our arrangements with Motorola. We cannot, however, assure you that we have correctly anticipated the required levels of services to be provided by Motorola or that we will be able to obtain similar services on comparable terms upon termination of our agreements with Motorola. Any material adverse change in Motorola s ability to supply these services could have a material adverse effect on our business or prospects. As part of Motorola, we had a number of formal and informal arrangements with other divisions of Motorola s Semiconductor Products Sector that provided us with equipment, finished products and other goods and services. Except as provided for in the agreements between Motorola and us, which are described under Business Sales, Marketing and Distribution and Business Manufacturing, future business dealings between Motorola and us will be on an arm s length basis. There can be no assurance that the arm s length nature of any future business relationship with Motorola will be as beneficial for us as our past relationship to Motorola. Dependence On Motorola And Other Key Customers For Our Products And Services If We Were To Lose One Or More Of Our Large Customers, Our Revenues And Profitability Could Be Adversely Affected. Motorola has historically constituted our largest original equipment manufacturer customer and accounted for approximately 8.6% of our net product revenues in 1999. As a result of our recapitalization, we are no longer part of Motorola, and our current and future product sales to Motorola and its affiliates will be on an arm s length basis. We cannot assure you that we will be able to maintain the level of historical product sales to Motorola or that we will be able to sell any products to Motorola or its affiliates. Notwithstanding our broad customer base, the loss of Motorola or any other sizable customer could harm our results of operations. Product sales to our ten largest customers accounted in the aggregate for approximately 51% of our net product revenues in 1999. Many of our customers operate in cyclical industries, and in the past we have experienced significant fluctuations from period to period in the volume of our products ordered. We have no agreements with any of our customers that impose minimum or continuing obligations to purchase our products. We cannot assure you that any of our customers will not significantly reduce orders or seek price reductions in the future or that the loss of one or more of such customers would not have a material adverse effect on our business or our prospects. Prior to our recapitalization, we and other divisions of Motorola s Semiconductor Products Sector provided manufacturing services to each other at cost (as calculated for financial accounting purposes). We and Motorola have agreed to continue providing manufacturing services to each other for limited periods of time following our recapitalization at fixed prices that are intended to approximate each party s cost of providing the services. We currently anticipate that Motorola, which has no purchase obligations after 2000, will purchase manufacturing services from us of approximately $47 million in 2000 and that any purchases thereafter will be insignificant. We could be adversely affected if Motorola does not purchase manufacturing services from us at the level we have anticipated, cancels these arrangements or discontinues using our manufacturing services after these agreements expire or if we are unable to find other uses for, or dispose of, the manufacturing facilities we currently use to provide these services in a manner that allows us to cover our fixed costs. Dependence On Motorola And Other Contractors For Manufacturing Services The Loss Of One Or More Of Our Sources For Manufacturing Services, Or Increases In The Prices Of Such Services, Could Adversely Affect Our Operations And Profitability. Prior to our recapitalization, we and other divisions of Motorola s Semiconductor Products Sector provided manufacturing services to each other at cost (as calculated for financial accounting purposes). In 1997, 1998 and the period from January 1, 1999 to August 3, 1999, the costs charged by other divisions of Motorola s Semiconductor Products Sector to us for these services amounted to $310.5 million, $266.8 million and $125.5 million respectively. From August 4, 1999 through December 31, 1999, we paid $101.3 million for manufacturing services to Motorola under our transition agreements. Motorola manufactures our emitter- We have filed an application for our common stock to be quoted on the Nasdaq National Market under the symbol ONNN. Table of Contents coupled logic products, which are high margin products that accounted for approximately 13% of our net product revenues in 1999. We currently have no other manufacturing source for these emitter-coupled logic products. We expect emitter-coupled logic products to remain one of our single most important product families over the next several years. We and Motorola have agreed to continue providing manufacturing services to each other (including Motorola s manufacturing of our emitter-coupled logic products) for limited periods of time following our recapitalization at fixed prices that are intended to approximate each party s cost of providing these services. Subject to our right to cancel upon six months written notice, we have minimum commitments to purchase manufacturing services from Motorola of approximately $88 million, $51 million, $41 million and $40 million in fiscal years 2000, 2001, 2002 and 2003, respectively, and have no purchase obligations thereafter. Based on our current budget, we anticipate that we will actually purchase manufacturing services from Motorola of approximately $150 million in 2000. We could be adversely affected if Motorola is unable to provide these services on a timely basis or if we are unable to relocate these manufacturing operations to our own facilities or to other third-party manufacturers on cost-effective terms or make other satisfactory arrangements prior to the time when these agreements expire. We also use other third-party contractors for manufacturing activities, primarily for the assembly and testing of final goods. In 1999, these contract manufacturers, including Astra, AAPI and ASE, accounted for approximately 23.9% of our cost of sales. Our agreements with these manufacturers typically require us to forecast product needs and commit to purchase services consistent with these forecasts, and in some cases require longer-term commitments in the early stages of the relationship. Our operations could be adversely affected if these contract relationships were disrupted or terminated, the cost of such services increased significantly, the quality of the services provided deteriorated or our forecasts proved to be materially incorrect. Dependence On Supply Of Raw Materials The Loss Of Our Sources Of Raw Materials, Or Increases In The Prices Of Such Goods, Could Adversely Affect Our Operations And Profitability. Our results of operations could be adversely affected if we are unable to obtain adequate supplies of raw materials in a timely manner or if the costs of our raw materials increase significantly or their quality deteriorates. Our manufacturing processes rely on many raw materials, including silicon wafers, copper lead frames, mold compound, ceramic packages and various chemicals and gases. We have no agreements with any of our suppliers that impose minimum or continuing supply obligations, and we obtain our raw materials and supplies from a large number of sources on a just-in-time basis. From time to time, suppliers may extend lead times, limit supplies or increase prices due to capacity constraints or other factors. Although we believe that our current supplies of raw materials are adequate, shortages could occur in various essential materials due to interruption of supply or increased demand in the industry. Prior to our recapitalization, most of our supplies were purchased jointly with Motorola. As part of our recapitalization we entered into an agreement with Motorola to provide for the transition of our supply management functions to a stand-alone basis. We are currently implementing this transition, which we expect to be complete by August 2000. We cannot assure you that we will be able to continue to procure adequate supplies of raw materials in a timely manner on terms comparable to those on which we procured raw materials as part of Motorola. Inability To Implement Our Business Strategy If We Are Unable To Implement Our Business Strategy, Our Revenues And Profitability May Be Adversely Affected. Our future financial performance and success are largely dependent on our ability to implement successfully our business strategy, which is described under Business Our Growth Strategy. We cannot assure you that we will successfully implement the business strategy described in this prospectus or that implementing our strategy will sustain or improve our results of operations. In particular, we cannot assure you that we will be able to build our position in markets with high growth potential, increase our sales, increase our manufacturing efficiency, optimize our manufacturing capacity, lower our production costs or make strategic acquisitions. Our business strategy is based on our assumptions about the future demand for our current products and the new products and applications we are developing and on our continuing ability to produce our products Investing in our common stock involves risks. See Risk Factors beginning on page 10. Table of Contents profitably. Each of these factors depends on our ability, among other things, to finance our operating and product development activities, maintain high quality and efficient manufacturing operations, relocate and close manufacturing facilities as part of our ongoing cost restructuring with minimal disruption to our operations, access quality raw materials and contract manufacturing services in a cost-effective and timely manner, protect our intellectual property portfolio and attract and retain highly-skilled technical, managerial, marketing and finance personnel. Our strategy also depends on our ability to implement our transition to a stand-alone company, which depends to a certain extent on Motorola s ability to provide transition services to us for limited periods of time and on our ability to provide or procure such services thereafter. Several of these and other factors that could affect our ability to implement our business strategy, such as risks associated with international operations, increased competition, legal developments and general economic conditions, are beyond our control. In addition, circumstances beyond our control and changes in our business or industry may require us to change our business strategy. Future Acquisitions We May Engage In Acquisitions That May Harm Our Operating Results, Cause Us To Incur Debt Or Assume Contingent Liabilities Or Dilute Our Stockholders. We have recently acquired Cherry Semiconductor Corporation, and we may in the future acquire other businesses, products and technologies. Successful acquisitions in the semiconductor industry are difficult to accomplish because they require, among other things, efficient integration of product offerings and manufacturing operations and coordination of sales and marketing and research and development efforts. The difficulties of integration may be increased by the necessity of coordinating geographically separated organizations, the complexity of the technologies being integrated and the necessity of integrating personnel with disparate business backgrounds and combining different corporate cultures. The integration of operations following an acquisition requires the dedication of management resources that may distract attention from the day-to-day business, and may disrupt key research and development, marketing or sales efforts. In addition, we may issue equity securities to pay for any future acquisitions, which could be dilutive to our existing stockholders. We may also incur debt or assume contingent liabilities in connection with acquisitions, which could harm our operating results. We financed our acquisition of Cherry Semiconductor with cash on hand and additional borrowings under our senior secured bank facilities. Risks Associated With International Operations Our International Operations Subject Us To Risks Inherent In Doing Business On An International Level That Could Adversely Impact Our Results Of Operations. Approximately 46%, 33% and 21% of our net product revenues in 1999 were derived from sales, directly or through distributors or electronic manufacturing service providers, to end users in the Americas, the Asia/Pacific region and Europe (including the Middle East), respectively. We maintain significant operations in Guadalajara, Mexico; Seremban, Malaysia; Carmona, the Philippines; Aizu, Japan; Leshan, China; Roznov, the Czech Republic; and Piestany, Slovakia. In addition, we rely on a number of contract manufacturers (primarily for assembly and testing) whose operations are primarily located in the Asia/Pacific region. We cannot assure you that we will be successful in overcoming the risks that relate to or arise from operating in international markets. Risks inherent in doing business on an international level include, among others, the following: economic and political instability; changes in regulatory requirements, tariffs, customs, duties and other trade barriers; transportation delays; power supply shortages and shutdowns; difficulties in staffing and managing foreign operations and other labor problems; currency convertibility and repatriation; taxation of our earnings and the earnings of our personnel; and PRICE $ A SHARE Table of Contents other risks relating to the administration of or changes in, or new interpretations of, the laws, regulations and policies of the jurisdictions in which we conduct our business. Our activities outside the United States are subject to additional risks associated with fluctuating currency values and exchange rates, hard currency shortages and controls on currency exchange. Motorola historically engaged in hedging activities to reduce the risk of adverse currency rate fluctuations affecting its overall business, but as a stand-alone company we now bear the risks and costs associated with any such hedging activities. Additionally, while our sales are primarily denominated in U.S. dollars, worldwide semiconductor pricing is influenced by currency rate fluctuations. See Management s Discussion and Analysis of Financial Condition and Results of Operations Market Risk. Dependence On Highly Skilled Personnel If We Fail To Attract And Retain Skilled Personnel, Our Results Of Operations And Competitive Position Could Deteriorate. Our success depends upon our ability to attract and retain highly-skilled technical, managerial, marketing and finance personnel. The market for personnel with such qualifications is highly competitive. In particular, analog component designers are difficult to attract and retain, and the failure to attract and retain analog component designers could compromise our ability to keep pace with our competitors in the market for analog components. We cannot assure you that we will be able to continue to attract and retain individuals with the qualifications necessary to operate our company most effectively. Dependence On Intellectual Property We Use A Significant Amount Of Intellectual Property In Our Business. Some Of That Intellectual Property Is Currently The Subject Of Disputes With Third Parties, And Litigation Could Arise In The Future. If We Are Unable To Protect The Intellectual Property We Use, Our Business May Be Adversely Affected. We rely on patents, trade secrets, trademarks, mask works and copyrights to protect our products and technologies. See Business Patents, Trademarks, Copyrights and Other Intellectual Property Rights. Some of our products and technologies are not covered by any patents or pending patent applications, and we cannot assure you that: any of the more than approximately 280 U.S. and 280 foreign patents and pending patent applications that Motorola has assigned, licensed or sublicensed to us in connection with our recapitalization will not lapse or be invalidated, circumvented, challenged or licensed to others; the license rights granted by Motorola in connection with our recapitalization will provide competitive advantages to us; or any of our pending or future patent applications will be issued or have the coverage originally sought. Moreover, we cannot assure you that: any of the trademarks, copyrights, trade secrets, know-how or mask works that Motorola has assigned, licensed or sublicensed to us in connection with our recapitalization will not lapse or be invalidated, circumvented, challenged or licensed to others; or any of our pending or future trademark, copyright, or mask work applications will be issued or have the coverage originally sought. Furthermore, we cannot assure you that our competitors or others will not develop products or technologies that are similar or superior to our products or technologies, duplicate our products or technologies or design around our protected technologies. In addition, effective patent, trademark, copyright and trade secret protection may be unavailable, limited or not applied for in the United States and in foreign countries. Also, we may from time to time in the future be notified of claims that we may be infringing third-party patents or other intellectual property rights. Motorola has agreed to indemnify us for a limited period of time with respect to some claims that our activities infringe on the intellectual property rights of others. If necessary or desirable, we may seek licenses under such patents or intellectual property rights. However, we cannot assure you that we will obtain such licenses or that the terms of any offered licenses will be acceptable to us. The failure to obtain a license from a third party for technologies we use could cause us to incur substantial Underwriting Proceeds to Price to Discounts and SCG Holding Public Commissions Corporation Table of Contents liabilities or to suspend the manufacture or shipment of products or our use of processes requiring the technologies. Litigation could cause us to incur significant expense, by adversely affecting sales of the challenged product or technologies and diverting the efforts of our technical and management personnel, whether or not such litigation is resolved in our favor. In the event of an adverse outcome in any such litigation, we may be required to: pay substantial damages; cease the manufacture, use, sale or importation of infringing products; expend significant resources to develop or acquire non-infringing technologies; discontinue the use of processes; or obtain licenses to the infringing technologies. We cannot assure you that we would be successful in any such development or acquisition or that any such licenses would be available to us on reasonable terms. Any such development, acquisition or license could require the expenditure of substantial time and other resources. We will also seek to protect our proprietary technologies, including technologies that may not be patented or patentable, in part by confidentiality agreements and, if applicable, inventors rights agreements with our collaborators, advisors, employees and consultants. We cannot assure you that these agreements will not be breached, that we will have adequate remedies for any breach or that persons or institutions will not assert rights to intellectual property arising out of our research. Environmental Liabilities; Other Governmental Regulation Regulatory Matters Could Adversely Affect Our Ability To Conduct Our Business And Could Require Expenditures That Could Have A Material Adverse Effect On Our Results Of Operations Or Financial Condition. Our manufacturing operations are subject to various environmental laws and regulations relating to the management, disposal and remediation of hazardous substances and the emission and discharge of pollutants into the air and water. Our operations are also subject to laws and regulations relating to workplace safety and worker health which, among other things, regulate employee exposure to hazardous substances. Motorola has agreed to indemnify us for environmental and health and safety liabilities related to the conduct or operations of our business or Motorola s ownership, occupancy or use of real property occurring prior to our recapitalization. We cannot assure you that such indemnification arrangements will cover all material environmental costs relating to pre-closing matters. Moreover, the nature of our operations exposes us to the continuing risk of environmental and health and safety liabilities related to events or activities occurring after our recapitalization. We believe that the future cost of compliance with existing environmental and health and safety laws and regulations (and liability for currently known environmental conditions) will not have a material adverse effect on our business or prospects. However, we cannot predict: changes in environmental or health and safety laws or regulations; the manner in which environmental or health and safety laws or regulations will be enforced, administered or interpreted; or the cost of compliance with future environmental or health and safety laws or regulations or the costs associated with any future environmental claims, including the cost of clean-up of currently unknown environmental conditions. Table of Contents Risks Related to Our Capital Structure Substantial Leverage Our Substantial Leverage Could Adversely Affect Our Ability To Operate Our Business. We are highly leveraged and have significant debt service obligations. As of December 31, 1999, after giving effect to the application of the net proceeds of this offering, we would have had total long-term indebtedness of approximately $1,117.9 million (excluding unused commitments), stockholders equity of approximately $184.8 million and annual interest expense of approximately $109.4 million. We will be permitted to incur significant additional debt in the future. Our substantial indebtedness could have important consequences to you, including the risks that: we will be required to use a substantial portion of our cash flow from operations to pay principal and interest on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, product development efforts and strategic acquisitions; our interest expense could increase if interest rates in general increase because a substantial portion of our debt will bear interest rates based on market rates; our level of indebtedness will increase our vulnerability to general economic downturns and adverse industry conditions; our debt service obligations could limit our flexibility in planning for, or reacting to, changes in our business and the semiconductor components industry; our indebtedness may restrict us from raising additional financing on satisfactory terms to fund working capital, capital expenditures, product development efforts and strategic acquisitions; and our substantial leverage could place us at a competitive disadvantage compared to our competitors who have less debt. Restrictive Covenants In Our Debt Instruments The Agreements Governing Our Indebtedness May Limit Our Ability To Finance Future Operations Or Capital Needs Or Engage In Other Business Activities That May Be In Our Interest. Our debt instruments contain various provisions that limit our management s discretion in the operation of our business by restricting our ability to: incur additional indebtedness; pay dividends and make other distributions; prepay subordinated debt; make restricted payments; enter into sale and leaseback transactions; create liens; sell and otherwise dispose of assets; and enter into transactions with affiliates. These restrictions may adversely affect our ability to finance our future operations or capital needs or engage in other business activities that may be in our interest. In addition, our senior bank facilities require us to maintain compliance with specified financial ratios. Our ability to comply with these ratios may be affected by events beyond our control. A breach of any of the provisions of our debt instruments could result in a default under our indebtedness, which would allow our lenders to declare all outstanding amounts due and payable. In such an event, our assets might not be sufficient to repay those amounts. Table of Contents Risks Related to the Securities Markets and Ownership of Our Common Stock Stock Price Fluctuations Our Stock Price May Be Volatile, Which Could Result In Substantial Losses For Investors Purchasing Shares In This Offering. The stock markets in general, and the markets for high technology stocks in particular, have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our common stock. Prior to this offering, you could not buy or sell our common stock publicly. Although we have applied to have our common stock quoted on the Nasdaq National Market, an active trading market may not develop or be sustained. We negotiated and determined the initial public offering price with the representatives of the underwriters based on several factors. The market price of the common stock after the offering may be less than the initial public offering price. The market price of the common stock may also fluctuate significantly in response to the following factors, some of which are beyond our control: variations in our quarterly operating results; changes in securities analysts estimates of our financial performance; changes in market valuations of similar companies; announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures, capital commitments, new products or product enhancements; loss of a major customer or failure to complete significant transactions; and additions or departures of key personnel. Shares Eligible For Future Sale Our Stock Price Could Be Affected Because A Substantial Number Of Shares Of Our Common Stock Will Be Available For Sale In The Future. Sales in the public market of a substantial number of shares of common stock or other equity or equity-related securities could depress the market price of the common stock and could impair our ability to raise capital through the sale of additional equity securities. A substantial number of shares of our common stock will be available for future sale. See Shares Eligible for Future Sale. Dilution Purchasers Of Common Stock In This Offering Will Suffer Immediate And Substantial Dilution. The initial public offering price is substantially higher than the net tangible book value per share of our common stock, which was negative $2.18 at December 31, 1999. As a result, you will experience immediate and substantial dilution of $15.14 in our net tangible book value per share, based on an assumed initial public offering price of $16.00 per share. This dilution will occur in large part because our earlier investors paid substantially less than the initial public offering price in this offering when they purchased their shares of common stock. You will experience additional dilution upon the exercise of outstanding stock options. See Dilution. Controlling Stockholder One Of Our Principal Stockholders Controls Our Company, Which Will Limit The Ability Of Our Other Stockholders To Influence The Outcome Of Director Elections And Other Matters Submitted For A Vote Of Our Stockholders. An affiliate of Texas Pacific Group owns 124,999,433 shares of our common stock, prior to giving effect to this offering, each share of which entitles its holder to one vote on stockholder actions. Following this offering, an affiliate of Texas Pacific Group will continue to own 124,999,433 shares, representing approximately 75% of the overall voting power of our outstanding stock, and will be able to: elect all of our directors and, as a result, control matters requiring board approval; control matters submitted to a stockholder vote, including mergers and consolidations with third parties and the sale of all or substantially all of our assets; and otherwise control or influence our business direction and policies. Per Share $ $ $ Total $ $ $ SCG Holding Corporation has granted the underwriters the right to purchase up to an additional 4,500,000 shares to cover over-allotments. The Securities and Exchange Commission and state securities regulators have not approved or disapproved these securities, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Morgan Stanley Co. Incorporated expects to deliver the shares to purchasers on , 2000. Table of Contents In addition, our certificate of incorporation provides that the provisions of Section 203 of the Delaware General Corporation Law, which relate to business combinations with interested stockholders, do not apply to us. See Principal Stockholders. Anti-Takeover Provisions Provisions In Our Charter Documents May Delay Or Prevent Acquisition Of Our Company, Which Could Decrease The Value Of Our Stock. Our certificate of incorporation and bylaws contain provisions that could make it harder for a third party to acquire us without the consent of our board of directors. These provisions: create a board of directors with staggered terms; permit only our board of directors or the chairman on our board of directors to call special meetings of stockholders; establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by stockholders at a meeting; prohibit stockholder action by written consent; authorize the issuance of blank check preferred stock, which is preferred stock with voting or other rights or preferences that could impede a takeover attempt and that our board of directors can create and issue without prior stockholder approval; and require the approval by holders of at least 66 2/3% of our outstanding common stock to amend any of these provisions in our certificate of incorporation or bylaws. Although we believe these provisions make a higher third-party bid more likely by requiring potential acquirors to negotiate with our board of directors, these provisions apply even if an initial offer may be considered beneficial by some stockholders. See Description of Capital Stock Anti-Takeover Effects of our Certificate of Incorporation and Bylaws. Table of Contents

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+RISK FACTORS YOU SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW BEFORE MAKING A DECISION TO BUY OUR COMMON STOCK. THE RISKS AND UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES FACING OUR COMPANY. ADDITIONAL RISKS AND UNCERTAINTIES NOT PRESENTLY KNOWN TO US OR THAT WE CURRENTLY DEEM IMMATERIAL ALSO COULD HARM OUR BUSINESS. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCUR, OUR BUSINESS COULD BE HARMED, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE AND YOU MAY LOSE ALL OR PART OF YOUR INVESTMENT. YOU SHOULD ALSO REFER TO THE OTHER INFORMATION CONTAINED IN THIS PROSPECTUS, INCLUDING THE FINANCIAL STATEMENTS AND RELATED NOTES. RISKS RELATING TO OUR COMPANY OUR FUTURE SALES ARE UNPREDICTABLE, OUR OPERATING RESULTS ARE LIKELY TO FLUCTUATE FROM QUARTER TO QUARTER, AND IF WE FAIL TO MEET THE EXPECTATIONS OF SECURITIES ANALYSTS OR INVESTORS, OUR STOCK PRICE COULD DECLINE SIGNIFICANTLY Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate in the future due to a variety of factors, some of which are outside of our control. As a result, period to period comparisons of our operating results are not necessarily meaningful or indicative of future performance. Furthermore, it is likely that in some future quarters our operating results will fall below the expectations of securities analysts or investors. If this occurs, the trading price of our common stock could decline. Factors that may affect our future operating results include: - the timing, number and size of orders for our products, as well as the relative mix of orders for each of our products, particularly the volume of lower margin telephone handsets; - the evolving and unpredictable nature of the economic, regulatory and political environments in China and other countries in which we market or plan to market our products; - aggressive price reductions by our competitors; - currency fluctuations; - market acceptance of our products and product enhancements; - the lengthy and unpredictable sales cycles associated with sales of our products combined with the impact of this variability on our suppliers' ability to provide us with components on a timely basis; and - longer collection periods of accounts receivable in China and other countries. The limited performance history of some of our products, our limited forecasting experience and processes and the emerging nature of our target markets make forecasting our future sales and operating results difficult. Our expense levels are based, in part, on our expectations regarding future sales, and these expenses are largely fixed, particularly in the short term. In addition, to enable us to promptly fill orders, we maintain inventories of finished goods, components and raw materials. As a result, we commit to considerable costs in advance of anticipated sales. In the past, a substantial portion of our sales in each quarter resulted from orders received and shipped in that quarter, and we have operated with a limited backlog of unfilled orders. Accordingly, we may not be able to reduce our costs in a timely manner to compensate for any unexpected shortfall between forecasted and actual sales. Any significant shortfall of sales may require us to maintain higher levels of inventories of finished goods, components and raw materials than we require, thereby increasing our risk of inventory obsolescence and corresponding inventory write-downs and write-offs. Although we have reserved against inventory obsolescence, we cannot guarantee that these reserves will be adequate to offset all write-downs or write-offs. WE HAVE A HISTORY OF LOSSES AND AN ACCUMULATED DEFICIT As of December 31, 1999, we had an accumulated deficit of approximately $34.8 million. We anticipate continuing to incur significant sales and marketing, research and development and general and administrative expenses and, as a result, we will need to generate higher revenues to sustain profitability. Numerous factors could negatively impact our results of operations, including a decrease in sales, price pressures and a fixed cost structure which could limit our ability to respond to declining revenues. Although our sales have grown in recent quarters, our past results should not be relied on as indications of our future performance. We cannot assure you that we will be able to remain profitable in future periods. COMPETITION IN OUR MARKETS MAY LEAD TO REDUCED PRICES, REVENUES AND MARKET SHARE We face intense competition in our target markets and expect competition to increase. Increased competition in our target markets may result in price reductions, reduced gross profit as a percentage of net sales and loss of market share. Our principal competitors for our different product lines include the following: - AIRSTAR SYSTEM: Alcatel Alsthom CGE, S.A.; Ericsson LM Telephone Co.; Huawei Technology Co., Ltd.; Lucent Technologies, Inc.; Motorola, Inc.; NEC Corporation; Siemens AG; and Zhongxing Telecommunications Equipment. - AN-2000 AND OMUX: Advanced Fibre Communications, Inc.; Alcatel; Bosch Telecom GmbH; ECI Telecom Ltd.; Ericsson; Fujitsu Limited; Huawei; Lucent; NEC; Nokia Corporation; Shanghai Bell Alcatel Mobile Communication; Siemens; and Zhongxing. - WACOS SYSTEM: Alcatel; Cisco Systems, Inc.; Clarent Corporation; Ericsson; Huawei; Lucent; Motorola; Nokia; Nortel Networks Corporation; Nuera Communications, Inc.; Siemens; Tachion Networks, Inc.; and Vienna Systems Corp. We are increasingly facing competition from domestic companies in China and believe that our strongest competition in the future may come from these companies, many of which operate under lower cost structures and more favorable governmental policies and with much larger sales forces than we do. Furthermore, other companies not presently offering competing products may also enter our target markets. Many of our competitors have significantly greater financial, technical, product development, sales, marketing and other resources than we do. Additionally, some competitors may be able to offer significant financing arrangements to service providers, in some cases facilitated by favorable government policies. Moreover, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties, including our current customers, to increase their ability to produce products that address the needs of service providers in our target markets. THE SUCCESS OF OUR BUSINESS DEPENDS ON A RELATIVELY SMALL NUMBER OF LARGE SYSTEM DEPLOYMENTS, AND ANY CANCELLATION, REDUCTION OR DELAY IN THESE DEPLOYMENTS COULD HARM OUR BUSINESS Our business is characterized by large system deployments for a relatively small number of service providers. In the twelve months ended December 31, 1999, two customers accounted for 30% and 11%, respectively, of our net sales. Our dependence on large system deployments makes our ability to provide systems in a timely and cost-effective manner critically important to our business. We have in the past experienced delays and encountered other difficulties in the installation and implementation of our systems. Various factors could cause future delays, including technical problems and the shortage of qualified technicians. Any delays or difficulties in deploying our systems, or the cancellation of any orders by service providers, could significantly harm our business. WE DO NOT HAVE SOME OF THE LICENSES WE REQUIRE TO SELL OUR NETWORK ACCESS PRODUCTS IN CHINA Beginning January 1, 1999, China's government required that all telecommunications equipment connected to public or private telecommunications networks within China be approved by the Ministry of Information Industry and the manufacturer of the equipment obtain a network access license for each of its products. Sellers are prohibited from selling or advertising for sale equipment for which its manufacturer has not obtained a network access license and may be liable for penalties in an amount up to three times earnings from the sale of any equipment sold beginning January 1, 1999 without a license. In addition, any unlicensed equipment may be required to be removed from the network. Failure to obtain the required licenses could require us to remove previously installed equipment and would prohibit us from making further sales of the unlicensed products in China, which would substantially harm our business. The regulations implementing these requirements are not very detailed, have not been applied by a court and may be interpreted and enforced by regulatory authorities in a number of different ways. Accordingly, we have obtained an opinion from our counsel in China as to which licenses we are required to obtain. Based upon this counsel's advice, we believe that we have obtained the required network access licenses for our AN-2000 system and bundled OMUX product. We have applied for a network access license for our Airstar system. The evaluation group for access networks under the Ministry of Information Industry has recommended that the Ministry of Information Industry issue a license for our Airstar system. However, we do not yet have this network access license and we cannot provide any assurance that a license will be issued for our Airstar system. We have also applied for network access licenses for our stand-alone OMUX product and for other products which we are no longer manufacturing but had previously sold to service providers in China. Network access licenses will be required for any additional products that we may develop for sale in China, including our WACOS system. Based upon verbal inquiries made by our counsel in China to the Ministry of Information Industry, we believe that for products which we sold before January 1, 1999, such as the Airstar system, no penalties will be imposed by the Ministry of Information Industry for sales we have made or will make during the period an application is pending. However, our counsel in China has advised us that China's governmental authorities may interpret or apply the regulations with respect to which licenses are required and the ability to sell a product while an application for the product license is pending differently, either of which could have a material adverse effect on our business and financial condition. OUR BUSINESS MAY SUFFER IF WE ARE UNABLE TO COLLECT PAYMENTS FROM OUR CUSTOMERS ON A TIMELY BASIS Our customers often must make a significant commitment of capital to purchase our products. As a result, any downturn in a customer's business that affected the customer's ability to pay us could harm our financial condition. Moreover, accounts receivable collection cycles historically tend to be much longer in China than in other markets. The failure of any of our customers to make timely payments could require us to write-off accounts receivable or increase our accounts receivable reserves, either of which could adversely affect our financial condition. A DECLINE IN BUSINESS ACTIVITY DURING CHINA'S LUNAR NEW YEAR MAY RESULT IN DECREASED SALES DURING OUR FIRST QUARTER Business activity in China declines considerably during the first quarter of each year in observance of the Lunar New Year. As a result, sales during the first quarter of our fiscal year have in the past typically been lower than sales during the fourth quarter of the preceding year and we expect this trend to continue in the future. We will continue to face this seasonality in the future and do not have the ability to forecast with any degree of certainty the impact of the decreased business activity during the Lunar New Year on our sales and operating results. OUR MARKET IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE, AND TO COMPETE EFFECTIVELY, WE MUST CONTINUALLY INTRODUCE NEW PRODUCTS THAT ACHIEVE MARKET ACCEPTANCE The emerging market for communications equipment in developing countries is characterized by rapid technological developments, frequent new product introductions and evolving industry and regulatory standards. Our success will depend in large part on our ability to enhance our network access and switching technologies and develop and introduce new products and product enhancements that anticipate changing service provider requirements and technological developments. We may need to make substantial capital expenditures and incur significant research and development costs to develop and introduce new products and enhancements. If we fail to timely develop and introduce new products or enhancements to existing products that effectively respond to technological change, our business, financial condition and results of operations could be materially adversely affected. From time to time, we or our competitors may announce new products or product enhancements, services or technologies that have the potential to replace or shorten the life cycles of our products and that may cause customers to defer purchasing our existing products, resulting in inventory obsolescence. Future technological advances in the communications industry may diminish or inhibit market acceptance of our existing or future products or render our products obsolete. Even if we are able to develop and introduce new products, we cannot assure you that they will gain market acceptance. Market acceptance of our products will depend on various factors including: - our ability to obtain necessary approvals from regulatory organizations; - the perceived advantages of the new products over competing products; - our ability to attract customers who have existing relationships with our competitors; - product cost relative to performance; and - the level of customer service available to support new products. Specifically, sales of our AN-2000 system outside of China depend, in part, on the adoption of the V5.2 standard in these markets. Additionally, sales of our Personal Access System, or PAS, the mobile component of our Airstar wireless system, will depend in part upon consumer acceptance of the mobility limitations of this service. The introduction of inexpensive wireless telephone service or other competitive services in China may have a material adverse effect on sales of our Airstar systems in China. If our existing or new products fail to achieve market acceptance for any reason, our business could be seriously harmed. OUR BUSINESS WILL SUFFER IF WE ARE UNABLE TO DELIVER QUALITY PRODUCTS ON A TIMELY AND COST EFFECTIVE BASIS Our operating results depend on our ability to manufacture products on a timely and cost effective basis. In the past, we have experienced reductions in yields as a result of various factors, including defects in component parts and human error in assembly. If we experience a deterioration in manufacturing performance or a delay in production of any of our products, we could experience delays in shipments and cancellations of orders. Moreover, networking products frequently contain undetected software or hardware defects when first introduced or as new versions are released. In addition, our products are often embedded in or deployed in conjunction with service providers' products which incorporate a variety of components produced by third parties. As a result, when a problem occurs, it may be difficult to identify the source of the problem. These problems may cause us to incur significant warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relation problems or loss of customers, any one of which could harm our business. If future demand for our products requires additional manufacturing capacity, we may invest in and build additional manufacturing facilities, most likely in China. However, we cannot assure you that the new manufacturing facilities will attain the same quality or level of efficiencies as our existing facilities. Alternatively, or in addition, we may contract with third party manufacturing facilities over which we may be unable to exercise the same degree of quality control as we can over our own facilities. We currently have no arrangements with any independent manufacturing facility, and we may not be able to obtain independent manufacturing sources on commercially attractive terms if and when needed. WE DEPEND ON SOME SOLE SOURCE AND OTHER KEY SUPPLIERS FOR HANDSETS, COMPONENTS AND MATERIALS USED IN OUR PRODUCTS, AND IF THESE SUPPLIERS FAIL TO PROVIDE US WITH ADEQUATE SUPPLIES OF HIGH QUALITY PRODUCTS, OUR COMPETITIVE POSITION, REPUTATION AND BUSINESS COULD BE HARMED Some handsets, components and materials used in our products are purchased from a single supplier or a limited group of suppliers. If any supplier is unwilling or unable to provide us with high quality components and materials in the quantities required and at the costs specified by us, we may not be able to find alternative sources on favorable terms, in a timely manner, or at all. Our inability to obtain or to develop alternative sources if and as required could result in delays or reductions in manufacturing or product shipments. Moreover, these suppliers may delay product shipments or supply us with inferior quality products. If any of these events occur, our competitive position, reputation and business could suffer. OUR ABILITY TO SOURCE A SUFFICIENT QUANTITY OF HIGH QUALITY HANDSETS AND OTHER COMPONENTS USED IN OUR PRODUCTS MAY BE LIMITED BY CHINA'S IMPORT RESTRICTIONS AND DUTIES AS WELL AS OUR ABILITY TO OBTAIN SUFFICIENT DOMESTIC MANUFACTURING CAPACITY We require a significant number of imported components to manufacture our products in China. Imported electronic components and other imported goods used in the operation of our business are subject to a variety of permit requirements, approval procedures and import duties. Failure to obtain necessary permits or approvals, administrative actions by China's government to limit imports of certain components, or non-payment of required import duties could subject us to penalties and fines and could adversely affect our ability to manufacture and sell our products in China. In addition, import duties increase the cost of our products and may make them less competitive. In particular, an integral component of our Airstar PAS system is the handset used by subscribers to make and receive mobile telephone calls. Our inability to obtain a sufficient number of high quality handsets could severely harm our business. Currently, a worldwide shortage of handsets exists. Although we have contracted with Japanese vendors to manufacture handsets under the UTStarcom label, we cannot assure you that they will be able to supply adequate quantities of handsets. Moreover, we must pay an import duty on each handset that we import into China, which may result in a competitive cost advantage for our competitors who produce handsets in China. As a result, we are evaluating various manufacturing alternatives within China. Currently, we are in the early stages of negotiations with third parties to manufacture handsets for us in China. We may be unable to enter into arrangements with third parties who are capable of producing adequate quantities of high-quality handsets. We also intend to develop the capacity to manufacture our own handsets. However, we may be unsuccessful in our efforts to do so. Additionally, to comply with manufacturing regulations in China we will need to obtain components for our handsets from local sources. These sources may not be able to produce adequate quantities of components that meet our quality standards. In addition, based upon our internal review, we believe that we are likely to be required to pay import duties and fines of up to approximately $500,000 to China's custom service for components we imported into China between 1994 and 1997 for which we did not pay the required import duties at the time we brought these components into China. We are presently seeking resolution of this matter with China's custom service. We cannot be sure what other action, if any, that China's custom service may take or whether additional fines or penalties may be imposed on us or our joint ventures. IF WE ARE UNABLE TO EXPAND OUR DIRECT SALES OPERATION IN CHINA AND INDIRECT DISTRIBUTION CHANNELS ELSEWHERE OR SUCCESSFULLY MANAGE OUR EXPANDED SALES ORGANIZATION, OUR OPERATING RESULTS MAY SUFFER Our distribution strategy focuses primarily on developing and expanding our direct sales organization in China and our indirect distribution channels outside of China. We may not be able to successfully expand our direct sales organization in China and the cost of any expansion may exceed the revenue generated from these efforts. Even if we are successful in expanding our direct sales organization in China, we may not be able to compete successfully against the significantly larger and better-funded sales and marketing operations of current or potential competitors. In addition, if we fail to develop relationships with significant international resellers or manufacturers' representatives, or if these resellers or representatives are not successful in their sales or marketing efforts, we may be unsuccessful in our expansion efforts outside China. WE EXPECT AVERAGE SELLING PRICES OF OUR PRODUCTS TO DECREASE WHICH MAY REDUCE OUR REVENUES, AND, AS A RESULT, WE MUST INTRODUCE NEW PRODUCTS AND REDUCE OUR COSTS IN ORDER TO MAINTAIN PROFITABILITY The average selling prices for communications access and switching systems and subscriber terminal products, such as handsets, in China have been declining as a result of a number of factors, including: - increased competition; - aggressive price reductions by competitors; - rapid technological change; and - price and performance enhancements. We have in the past experienced and expect in the future to experience substantial period-to-period fluctuations in operating results due to declining average selling prices. We anticipate that average selling prices of our products will decrease in the future in response to product introductions by us or our competitors or other factors, including price pressures from customers. Therefore, we must continue to develop and introduce new products and enhancements to existing products that incorporate features that can be sold at higher average selling prices. Failure to do so could cause our revenues and gross profit, as a percentage of net sales, to decline. Our cost reduction efforts may not allow us to keep pace with competitive pricing pressures or lead to improved gross profit, as a percentage of net sales. In order to be competitive, we must continually reduce the cost of manufacturing our products through design and engineering changes. We may not be successful in redesigning our products or delivering our products to market in a timely manner. We cannot assure you that any redesign will result in sufficient cost reductions to allow us to reduce the prices of our products to remain competitive or to improve or maintain our gross profit, as a percentage of net sales. SERVICE PROVIDERS SOMETIMES EVALUATE OUR PRODUCTS FOR LONG AND UNPREDICTABLE PERIODS WHICH CAUSES THE TIMING OF PURCHASES AND OUR RESULTS OF OPERATIONS TO BE UNPREDICTABLE The period of time between our initial contact with a service provider and the receipt of an actual purchase order may span a year or more. During this time, service providers may subject our products to an extensive and lengthy evaluation process before making a purchase. The length of these qualification processes may vary substantially by product and service provider, making our results of operations unpredictable. We may incur substantial sales and marketing expenses and expend significant management effort during this process, which ultimately may not result in a sale. These qualification processes often make it difficult to obtain new customers, as service providers are reluctant to expend the resources necessary to qualify a new supplier if they have one or more existing qualified sources. OUR INABILITY TO EXERCISE COMPLETE CONTROL OVER OUR SUBSIDIARIES MAY BE DETRIMENTAL TO OUR BUSINESS A considerable portion of our operations is and will continue to be conducted through direct and indirect subsidiaries. For example, we own an 88% interest in a joint venture which operates the Zhejiang manufacturing facility and a 51% interest in a joint venture which operates the Guangdong manufacturing facility. Even though we may own a majority interest in these joint ventures, we do not have sole power to control all of the policies and decisions of these jointly-owned subsidiaries. Under China law governing Sino-foreign joint ventures, equity holders exercise rights primarily through the board of directors, which constitutes the highest authority of the joint venture. Although we own a majority of the Guangdong joint venture, we are only entitled to appoint a minority of the directors to the joint venture's board of directors, which prevents us from controlling the actions of the board. Moreover, even though we hold a majority of the board seats in the Zhejiang joint venture, China law requires unanimous approval of the board of directors for some significant corporate actions, including: - amendment of the Articles of Association of the joint venture; - liquidation or dissolution of the joint venture; - any increase, decrease or transfer of equity interests of any party to the joint venture; and - a merger of the joint venture with another economic entity. Our operating results and cash flow depend on the operating results and cash flow of our subsidiaries and the payment of funds by those subsidiaries to us. These subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay dividends or otherwise provide financial benefits to us. Moreover, with respect to our Guangdong manufacturing joint venture, any payment of dividends to us must be agreed to by our joint venture partner, whose interests in receiving dividend distributions may not coincide with ours. In addition, applicable law in some countries including China limits the ability of a subsidiary to pay dividends for various reasons including the absence of sufficient distributable reserves. In the event of any insolvency, bankruptcy or similar proceedings, creditors of the subsidiaries would generally be entitled to priority over us with respect to assets of the affected subsidiary. In addition, because our joint venture partners in both Zhejiang and Guangdong provinces are affiliated with the provincial Posts and Telecommunications Administrations that operate the telecommunication networks in these areas, if we fail to maintain these joint ventures, sales to our customers located in these areas may decrease. OUR MULTI-NATIONAL OPERATIONS SUBJECT US TO VARIOUS ECONOMIC, POLITICAL, REGULATORY AND LEGAL RISKS We market and sell our products in China and other markets. The expansion of our existing multi-national operations and entry into additional international markets will require significant management attention and financial resources. Multi-national operations are subject to inherent risks, including: - difficulties in designing products that are compatible with varying international communications standards; - longer accounts receivable collection periods and greater difficulty in accounts receivable collection; - unexpected changes in regulatory requirements; - changes to import and export regulations, including quotas, tariffs and other trade barriers; - delays or difficulties in obtaining export and import licenses; - potential foreign exchange controls and repatriation controls on foreign earnings; - exchange rate fluctuations and currency conversion restrictions; - the burdens of complying with a variety of foreign laws and regulations; - difficulties and costs of staffing and managing multi-national operations; - reduced protection for intellectual property rights in some countries; - potentially adverse tax consequences; and - political and economic instability. Multinational companies are required to establish intercompany pricing for transactions between their separate legal entities operating in different taxing jurisdictions. These intercompany transactions are subject to audit by taxing authorities in the jurisdictions in which multinational companies operate. An additional tax liability may be incurred if it is determined that intercompany pricing was not done at arm's length. We believe we have adequately estimated and recorded our liability arising from intercompany pricing, but we cannot assure you that an additional tax liability will not result from audits of our intercompany pricing policies. In markets outside of China, we rely on a number of original equipment manufacturers, or OEMs, and third-party distributors and agents to market and sell our network access products. If these OEMs, distributors or agents fail to provide the support and effort necessary to service developing markets effectively, our ability to maintain or expand our operations outside of China will be negatively impacted. We cannot assure you that we will successfully compete in these markets, that our products will be accepted or that we will successfully overcome the risks associated with international operations. Our international sales are generally denominated in local currencies. Due to the limitations on converting Renminbi, we are limited in our ability to engage in currency hedging activities in China. We do not currently engage in currency hedging activities with respect to any other currencies. Although the impact of currency fluctuations to date has been insignificant, fluctuations in currency exchange rates in the future may have a material adverse effect on our results of operations. OUR FAILURE TO MEET INTERNATIONAL AND GOVERNMENTAL PRODUCT STANDARDS COULD BE DETRIMENTAL TO OUR BUSINESS Many of our products are required to comply with numerous government regulations and standards, which vary by market. As standards for products continue to evolve, we will need to modify our products or develop and support new versions of our products to meet emerging industry standards, comply with government regulations and satisfy the requirements necessary to obtain approvals. Our inability to obtain regulatory approval and meet established standards could delay or prevent our entrance into or force our departure from markets. OUR RECENT GROWTH HAS STRAINED OUR RESOURCES, AND IF WE ARE UNABLE TO MANAGE AND SUSTAIN OUR GROWTH, OUR OPERATING RESULTS WILL BE NEGATIVELY AFFECTED We have recently experienced a period of rapid growth and anticipate that we must continue to expand our operations to address potential market opportunities. If we fail to implement or improve systems or controls or to manage any future growth and expansion effectively, our business could suffer. Our expansion has placed and will continue to place a significant strain on our management, operational, financial and other resources. Many of the members of our management team have limited experience in the management of rapidly growing companies. To manage our growth effectively, we will need to take various actions, including: - enhancing management information systems and forecasting procedures; - further developing our operating, administrative, financial and accounting systems and controls; - maintaining close coordination among our engineering, accounting, finance, marketing, sales and operations organizations; - expanding, training and managing our employee base; and - expanding our finance, administrative and operations staff. OUR SUCCESS IS DEPENDENT ON CONTINUING TO HIRE AND RETAIN QUALIFIED PERSONNEL, AND IF WE ARE NOT SUCCESSFUL IN ATTRACTING AND RETAINING THESE PERSONNEL, OUR BUSINESS WOULD BE HARMED The success of our business depends in significant part upon the continued contributions of key technical and senior management personnel, many of whom would be difficult to replace. In particular, our success depends in large part on the knowledge, expertise and services of Hong Liang Lu, our President and Chief Executive Officer, and Ying Wu, our Executive Vice President and Chief Executive Officer of China Operations. The loss of any key employee, the failure of any key employee to perform satisfactorily in his or her current position or our failure to attract and retain other key technical and senior management employees could have a significant negative impact on our operations. To effectively manage our recent growth as well as any future growth, we will need to recruit, train, assimilate, motivate and retain qualified employees. Competition for qualified employees is intense, and the process of recruiting personnel with the combination of skills and attributes required to execute our business strategy can be difficult, time-consuming and expensive. We are actively searching for research and development engineers and sales and marketing personnel, who are in short supply. Additionally, we have a need for and have experienced difficulty in finding qualified accounting personnel knowledgeable in U.S. and China accounting standards. If we fail to attract, hire, assimilate or retain qualified personnel, our business would be harmed. Competitors and others have in the past and may in the future attempt to recruit our employees. In addition, companies in the communications industry whose employees accept positions with competitors frequently claim that the competitors have engaged in unfair hiring practices. We may be the subject of these types of claims in the future as we seek to hire qualified personnel. Some of these claims may result in material litigation and disruption to our operations. We could incur substantial costs in defending ourselves against these claims, regardless of their merits. ANY ACQUISITIONS THAT WE UNDERTAKE COULD BE DIFFICULT TO INTEGRATE, DISRUPT OUR BUSINESS, DILUTE OUR STOCKHOLDERS AND HARM OUR OPERATING RESULTS We recently acquired Wacos, Inc., a research and development subsidiary, through a merger. We continually evaluate additional acquisition prospects that would complement our existing product offerings, augment our market coverage, enhance our technological capabilities, or that may otherwise offer growth opportunities. Acquisitions of other companies may result in dilutive issuances of equity securities, the incurrence of debt and the amortization of expenses related to goodwill and other intangible assets. In addition, acquisitions involve numerous risks, including difficulties in the assimilation of operations, technologies, products and personnel of the acquired company, diversion of management's attention from other business concerns, risks of entering markets in which we have no direct or limited prior experience, and the potential loss of key employees of ours and the acquired company. WE MAY EXPERIENCE DIFFICULTY IN IDENTIFYING, FORMING AND MAINTAINING NEW BUSINESS VENTURES THAT ARE IMPORTANT TO THE DEVELOPMENT OF OUR BUSINESS We have invested, and expect to continue to invest, significant capital in new business ventures. We cannot assure you that we will be able to continue to identify suitable parties for new ventures in the future. The failure to form or maintain new ventures could significantly limit our ability to expand our operations. Moreover, these new ventures or investments require significant management time, involve a high degree of risk and will present significant challenges. We cannot assure you that these activities will be successful or that we will realize appropriate returns on these activities. Additionally, if any venture or investment fails, our business could be negatively impacted. WE MAY BE UNABLE TO ADEQUATELY PROTECT OUR INTELLECTUAL PROPERTY AND MAY BE SUBJECT TO CLAIMS THAT WE INFRINGE THE INTELLECTUAL PROPERTY OF OTHERS, EITHER OF WHICH COULD SUBSTANTIALLY HARM OUR BUSINESS We rely on a combination of patents, copyrights, trade secret laws and contractual obligations to protect our technology. Although we have applied for several patents in the United States, one of which has issued, as well as in other countries, we cannot assure you that any additional patents will issue as a result of pending patent applications or that our issued patents will be upheld. Moreover, we have not yet obtained patents in China. We can give no assurance that we will be able to obtain patents in China on our products or the technology that we use to manufacture our products. Our joint ventures in China rely upon our trademarks, technology and know-how to manufacture and sell our products. We cannot guarantee that these and other intellectual property protection measures will be sufficient to prevent misappropriation of our technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to ours. In addition, the legal systems of many foreign countries, including China, do not protect intellectual property rights to the same extent as the legal system of the United States. If we are unable to adequately protect our proprietary information, our business, financial condition and results of operations could be materially adversely affected. The increasing dependence of the communications industry on proprietary technology has resulted in frequent litigation based on allegations of the infringement of patents and other intellectual property. In the future we may be subject to litigation to defend against claimed infringements of the rights of others or to determine the scope and validity of the proprietary rights of others. Future litigation also may be necessary to enforce and protect our trade secrets and other intellectual property rights. Any intellectual property litigation could be costly and could cause diversion of management's attention from the operation of our business. Adverse determinations in any litigation could result in the loss of our proprietary rights, subject us to significant liabilities or require us to seek licenses from third parties which may not be available on commercially reasonable terms, if at all. We could also be subject to court orders preventing us from manufacturing or selling our products. PROBLEMS RELATED TO YEAR 2000 ISSUE COULD HARM OUR BUSINESS The potential for software failures due to processing errors from calculations using the year 2000 date is a known risk. We recognize the need to ensure that our operations and products will not be adversely impacted by year 2000 software failures. We have established procedures for evaluating and managing the risks and costs associated with this problem and believe that our internal computer systems, including our accounting, sales and technical support automation systems, are currently year 2000 compliant. Even though our operations have not been materially affected by the year 2000 issue, our systems and those of other companies on which our systems and operations rely could still experience year 2000 problems. RISKS RELATING TO CHINA Sales in China account for substantially all of our sales. Approximately $102.9 million, or 97.9%, of our sales in 1998, and $186.1 million, or 99.3% of our sales in 1999, occurred in China. Additionally, a substantial portion of our fixed assets are located in China. Of our total fixed assets, approximately 46.4% as of December 31, 1998 and 53.7% as of December 31, 1999 were in China. We expect to make further investments in China in the future. Therefore, our business, financial condition and results of operations are to a significant degree subject to economic, political and social events in China. DEVALUATION IN THE VALUE OF THE RENMINBI AND FLUCTUATIONS IN EXCHANGE RATES COULD ADVERSELY AFFECT OUR FINANCIAL RESULTS Exchange rate fluctuations could have a substantial negative impact on our financial condition and results of operations. We purchase substantially all of our materials in the United States and Japan and a significant portion of our cost of goods sold is incurred in U.S. dollars and Japanese yen. A significant portion of our operating expenses are incurred in U.S. dollars. At the same time, most of our sales are denominated in Renminbi. The value of the Renminbi is subject to changes in China's governmental policies and to international economic and political developments. Although the official exchange rate for the conversion of Renminbi to U.S. dollars has remained stable, with the Renminbi appreciating slightly against the U.S. dollar since 1994, the exchange rate experienced significant volatility prior to 1994 including periods of sharp devaluation. There can be no assurance that exchange rates will not become volatile or that the Renminbi will not devalue again against the U.S. dollar. In the past, financial markets in many Asian countries have experienced severe volatility and, as a result, some Asian currencies have experienced significant devaluation from time to time. The devaluation of some Asian currencies may have the effect of rendering exports from China more expensive and less competitive and therefore place pressure on China's government to devalue the Renminbi. Any devaluation of the Renminbi could result in an increase in volatility of Asian currency and capital markets. Future volatility of Asian financial markets could have an adverse impact on our ability to expand our product sales into Asian markets outside of China. Moreover, due to the limitations on the convertibility of Renminbi, we are limited in our ability to engage in currency hedging activities in China and do not currently engage in currency hedging activities with respect to international sales outside of China. CURRENCY RESTRICTIONS IN CHINA MAY LIMIT THE ABILITY OF OUR SUBSIDIARIES AND JOINT VENTURES IN CHINA TO OBTAIN AND REMIT FOREIGN CURRENCY NECESSARY FOR THE PURCHASE OF IMPORTED COMPONENTS AND MAY LIMIT OUR ABILITY TO OBTAIN AND REMIT FOREIGN CURRENCY IN EXCHANGE FOR RENMINBI EARNINGS China's government imposes controls on the convertibility of Renminbi into foreign currencies and, in certain cases, the remittance of currency out of China. Under the current foreign exchange control system, sufficient foreign currency may not be available to satisfy our currency needs. Shortages in the availability of foreign currency may restrict the ability of our Chinese subsidiaries to obtain and remit sufficient foreign currency to pay dividends to us, or otherwise satisfy their foreign currency denominated obligations such as payments to us for components which we export to them and for technology licensing fees. We may also experience difficulties in completing the administrative procedures necessary to obtain and remit needed foreign currency. Moreover, we cannot assure you that China's government will continue the policy of making the Renminbi convertible under current accounts. Our inability to convert and remit our sales received in Renminbi into U.S. dollars and make necessary remittances could have a material adverse effect on our business, financial condition and results of operations. Our business could be substantially harmed if we are unable to convert our sales received in Renminbi into U.S. dollars. Under existing foreign exchange laws, Renminbi held by our China subsidiaries can be converted into foreign currencies and remitted out of China to pay current account items such as payments to suppliers for imports, labor services, payment of interest on foreign exchange loans and distributions of dividends so long as the subsidiaries have adequate amounts of Renminbi to purchase the foreign currency. Expenses of a capital nature such as the repayment of bank loans denominated in foreign currencies, however, require approval from appropriate governmental authorities before Renminbi can be used to purchase foreign currency and then remitted out of China. This system could be changed at any time by executive decision of the State Council to impose limits on current account convertibility of the Renminbi or other similar restrictions. Moreover, even though the Renminbi is intended to be freely convertible under the current account, the State Administration of Foreign Exchange, which is responsible for administering China's foreign currency market, has a significant degree of administrative discretion in implementing the laws. From time to time, the State Administration of Foreign Exchange has used this discretion in ways which effectively limit the convertibility of current account payments and restrict remittances out of China. Furthermore, in many circumstances the State Administration of Foreign Exchange must approve foreign currency conversions and remittances. Under the current foreign exchange control system, sufficient foreign currency may not be available at a given exchange rate to satisfy our currency demands. CHANGES WITHIN CHINA'S COMMUNICATIONS MARKET COULD HARM OUR BUSINESS We derive substantially all of our sales from local telecommunications service providers in China which utilize network access equipment in the continued expansion and upgrading of China's communications infrastructure. The continued development of the communications infrastructure in China correspondingly depends, in part, on the demand for voice and data services in China and China's governmental policy. Although this industry has grown rapidly in the past, we cannot assure you that it will continue to grow in the future. Any reduced demand for voice and data services, any other downturn or other adverse changes in the China communications industry or the adoption or enforcement of government policies that limit or prohibit our ability to manufacture, market or sell our products could severely harm our business. CHINA'S TELECOMMUNICATIONS INDUSTRY IS SUBJECT TO EXTENSIVE GOVERNMENT REGULATION AND HAS RECENTLY BEEN RESTRUCTURED, WHICH HAS LED TO UNCERTAINTY China's telecommunications industry is heavily regulated by the Ministry of Information Industry. The Ministry of Information Industry controls the 33 provincial Posts and Telecommunications Administrations that exercise regulatory responsibility over the telecommunications industries in their respective provinces. The Ministry of Information Industry has broad discretion and authority to regulate all aspects of the telecommunications and information technology industry in China including managing spectrum bandwidths, setting network equipment specifications and standards and drafting laws and regulations related to the electronics and telecommunications industries. As part of the Chinese government's industry restructuring initiatives, the regulatory functions of the Ministry of Information Industry and the Posts and Telecommunications Administrations will be separated from the operational functions of the state-owned companies under their control. Following this separation, it is expected that the Ministry of Information Industry will act exclusively as the industry regulator and will no longer manage the day-to-day operations of telecommunications service providers in China. The separation of the regulatory and operational functions of the Ministry of Information Industry and the Posts and Telecommunications Administrations has not been completed. As a result, the Ministry of Information Industry continues to exercise administrative control over the operational goals and policies of telecommunications service providers formerly under the control of the China Telecom system. In addition, the provincial Posts and Telecommunications Administrations continue to operate the fixed line telephone systems in their respective provinces. We cannot predict when complete separation of the regulatory and operational functions of the Ministry of Information Industry and the provincial Posts and Telecommunications Administrations will be achieved. China does not yet have a national telecommunications law. The Ministry of Information Industry, under the direction of the State Council, is currently preparing a draft of the Telecommunications Law of the People's Republic of China for ultimate submission to the National People's Congress for review and adoption. It is unclear if and when the Telecommunications Law will be adopted. If the Telecommunications Law is adopted, we expect it to become the basic telecommunications statute and the source of telecommunications regulations in China. Although we expect that a Telecommunications Law would have a positive effect on the overall development of the telecommunications industry in China, we do not know the nature and scope of regulation that it would create. Accordingly, we cannot predict whether it will have a positive or negative effect on us or on some or all aspects of our business. The Ministry of Information Industry has broad discretion to apply standards in deciding what types of equipment may be connected to the national telecommunications networks, the forms and types of services that may be offered to the public and the content of material available in China over the Internet. If the Ministry of Information Industry sets standards with which we are unable to comply, our ability to sell product in China may be limited, resulting in substantial harm to our operations. CHINA CLOSELY RESTRICTS ACTIVITIES OF FOREIGN INVESTORS IN THE TELECOMMUNICATIONS INDUSTRY China's government and its agencies, including the Ministry of Information Industry and the State Council, regulate foreign investment in the telecommunications industry through the promulgation of various laws and regulations and the issuance of various administrative orders and decisions. Foreign investment enterprises, companies and individuals are prohibited from investing and participating in the operation and management of telecommunications networks without special approval by the State Council. In addition, they are restricted from manufacturing analog mobile communications systems, including wireless telephones. We cannot assure you that China will not promulgate new laws or regulations, or issue administrative or judicial decisions or interpretations, which would further restrict or bar foreigners from engaging in telecommunications-related activities. The promulgation of laws or regulations or the issuance of administrative orders or judicial decisions or interpretations restricting or prohibiting telecommunications activities by foreigners could have a substantial impact on our ongoing operations. OUR CUSTOMERS IN CHINA ARE PART OF THE CHINA TELECOM SYSTEM AND ARE SUBJECT TO ITS ULTIMATE CONTROL. WE UNDERSTAND THAT CHINA TELECOM RECENTLY PROHIBITED ALL POSTS AND TELECOMMUNICATIONS BUREAUS IN CHINA FROM PURCHASING LOW-MOBILITY WIRELESS ACCESS SYSTEMS, SUCH AS OUR PAS SYSTEM, FOR IMPLEMENTATION IN LARGE CITIES Each of the local Posts and Telecommunications Bureaus in China which comprise our existing or potential customers is part of the China Telecom system and subject to its ultimate control. Accordingly, China Telecom may issue policy statements or make other decisions which govern the equipment purchasing decisions of all of our customers in China. For example, we understand that China Telecom recently prohibited all Posts and Telecommunications Bureaus from purchasing low-mobility wireless access systems, such as our PAS system, for implementation in large cities. While to date we have not marketed or sold our PAS systems in large cities, we may wish to do so in the future. As the majority of our sales are generated from our operations in China, this decision of China Telecom or other decisions by China Telecom could cause substantial harm to our business. CHINA'S GOVERNMENT POLICIES COULD IMPACT OUR BUSINESS Since 1978, China's government has been and is expected to continue reforming its economic and political systems. These reforms have resulted in and are expected to continue to result in significant economic and social development in China. Many of the reforms are unprecedented or experimental and may be subject to change or readjustment due to a number of political, economic and social factors. We believe that the basic principles underlying the political and economic reforms will continue to be implemented and provide the framework for China's political and economic system. New reforms or the readjustment of previously implemented reforms could have a significant negative effect on our operations. Changes in China's political, economic and social conditions and governmental policies which could have a substantial impact on our business include: - new laws and regulations or the interpretation of those laws and regulations; - the introduction of measures to control inflation or stimulate growth; - changes in the rate or method of taxation; - the imposition of additional restrictions on currency conversion and remittances abroad; and - any actions which limit our ability to develop, manufacture, import or sell our products in China, or to finance and operate our business in China. CHINA'S ECONOMIC POLICIES COULD IMPACT OUR BUSINESS The economy of China differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development in various respects such as structure, government involvement, level of development, growth rate, capital reinvestment, allocation of resources, self-sufficiency, rate of inflation and balance of payments position. In the past, the economy of China has been primarily a planned economy subject to one- and five-year state plans adopted by central government authorities and largely implemented by provincial and local authorities which set production and development targets. Since 1978, increasing emphasis had been placed on decentralization and the utilization of market forces in the development of China's economy. Economic reform measures adopted by China's government may be inconsistent or ineffectual, and we may not in all cases be able to capitalize on any reforms. Further, these measures may be adjusted or modified in ways which could result in economic liberalization measures that are inconsistent from time to time or from industry to industry or across different regions of the country. China's economy has experienced significant growth in the past decade. This growth, however, has been accompanied by imbalances in China's economy and has resulted in significant fluctuations in general price levels, including periods of inflation. China's government has implemented policies from time to time to increase or restrain the rate of economic growth, control periods of inflation or otherwise regulate economic expansion. While we may be able to benefit from the effects of some of these policies, these policies and other measures taken by China's government to regulate the economy could also have a significant overall impact on economic conditions in China with a resulting negative impact on our business. CHINA'S EXPECTED ENTRY INTO THE WTO CREATES UNCERTAINTY AS TO THE FUTURE ECONOMIC AND BUSINESS ENVIRONMENTS IN CHINA China has been attempting to join the World Trade Organization and recently signed a bilateral trade agreement with the United States which has enabled China to gain the support of the United States in China's attempt to enter the WTO. With this agreement concluded, and subject to the support of other member countries, China is expected to enter into the WTO as early as some time in 2000. Although China has been reducing tariff levels over the past several years, entry into the WTO will require China to further reduce tariffs and eliminate other trade restrictions. While China's entry into the WTO and related relaxation of trade restrictions may lead to increased foreign investment, it may also lead to increased competition in China's markets from international companies. Whether or not China is accepted into the WTO, the impact on China's economy and our business is uncertain. IF TAX BENEFITS AVAILABLE TO OUR SUBSIDIARIES LOCATED IN CHINA ARE REDUCED OR REPEALED, OUR BUSINESS COULD SUFFER Our subsidiaries located in China enjoy tax benefits in China which are generally available to foreign investment enterprises, including full exemption from national enterprise income tax for two years starting from the first profit-making year and/or a 50% reduction in national income tax rate for the following three years. In addition, local enterprise income tax is often waived or reduced during this tax holiday/incentive period. Under current regulations in China, foreign investment enterprises that have been accredited as technologically advanced enterprises are entitled to additional tax incentives. These tax incentives vary in different locales and could include preferential national enterprise income tax treatment at 50% of the usual rates for different periods of time. All of our active subsidiaries in China were accredited as technologically advanced enterprises. These tax incentives may be repealed or reduced in the future. If these tax incentives are abolished before our subsidiaries in China can take full advantage of them, the tax liability of these subsidiaries will increase, which will negatively impact our financial condition and results of operations. CHINA'S LEGAL SYSTEM EMBODIES UNCERTAINTIES THAT COULD NEGATIVELY IMPACT OUR BUSINESS China has a civil law legal system. Although often used by judges for guidance, decided court cases do not have binding legal effect on future decisions. Since 1979, many new laws and regulations covering general economic matters have been promulgated in China. Despite this activity to develop the legal system, China's system of laws is not yet complete. Even where adequate law exists in China, enforcement of existing laws or contracts based on existing law may be uncertain and sporadic and it may be difficult to obtain swift and equitable enforcement, or to obtain enforcement of a judgment by a court of another jurisdiction. The relative inexperience of China's judiciary in many cases creates additional uncertainty as to the outcome of any litigation. Further, interpretation of statutes and regulations may be subject to government policies reflecting domestic political changes. China has adopted a broad range of related laws, administrative rules and regulations that govern the conduct and operations of foreign investment enterprises and restrict the ability of foreign companies to conduct business in China. These laws, rules and regulations provide some incentives to encourage the flow of investment into China, but also subject foreign companies, and foreign investment enterprises including our subsidiaries in China, to a set of restrictions which may not always apply to domestic companies in China. Although China is increasingly according foreign companies and foreign investment enterprises established in China the same rights and privileges as Chinese domestic companies in anticipation of China's entry into the WTO, these special laws, administrative rules and regulations governing foreign companies and foreign investment enterprises may still place us and our subsidiaries at a disadvantage in relation to Chinese domestic companies and may adversely affect our competitive position. Moreover, as China's legal system develops, the promulgation of new laws, changes to existing laws and the pre-emption of local regulations by national laws may adversely affect foreign investors and companies. Many of our activities and products in China are subject to administrative review and approval by various national and local agencies of China's government. Because of the changes occurring in China's legal and regulatory structure, there can be no assurance that we will be able to secure the requisite governmental approval for our activities and products. Failure to obtain the requisite government approval for any of our activities or products could substantially harm our business. RISKS RELATED TO THE OFFERING OUR STOCK PRICE MAY BE VOLATILE AND YOU MAY BE UNABLE TO SELL YOUR SHARES AT OR ABOVE THE OFFERING PRICE Prior to this offering, there has been no public market for our common stock. We cannot assure you that an active trading market for our common stock will develop or be sustained after the offering. The initial public offering price will be determined by negotiations between us and the underwriters, and may not be indicative of the market price of our common stock after the offering. Investors may not be able to resell their shares at or above the initial public offering price due to a number of factors, including: - actual or anticipated fluctuations in operating results; - changes in expectations as to future financial performance or changes in financial estimates or buy/sell recommendations of securities analysts; - publications or technological innovations by us or our competitors; and - the operating and stock price performance of other comparable companies. In addition, domestic and international stock markets have recently experienced extreme price and trading volume volatility, particularly in the high technology sectors of these markets. This volatility has significantly affected the market prices of securities of many technology companies for reasons often unrelated to the operating performance of the specific companies. These fluctuations may adversely affect the trading price of our common stock, regardless of our actual operating performance. Following initial public offerings, the trading prices for stocks of many Internet, communications equipment and other technology-related companies have reached levels that bear no relationship to the operating performance of these companies. These trading prices are generally not sustainable and could fluctuate significantly. If our common stock trades to high levels following this offering, it could be followed by a significant decline. OUR EXISTING STOCKHOLDERS HAVE SIGNIFICANT CONTROL OF OUR MANAGEMENT AND AFFAIRS, WHICH THEY COULD EXERCISE AGAINST YOUR BEST INTERESTS Following the completion of this offering, SOFTBANK CORP. and its related companies will beneficially own 52.3% of our outstanding stock. As a result, SOFTBANK will have the ability to control all matters submitted to our stockholders for approval and exert significant influence over our management and affairs. This concentration of ownership may delay or prevent a change of control or discourage a potential acquiror from making a tender offer or otherwise attempting to obtain control of our company, which could decrease the market price of our common stock. Matters that could require stockholder approval include: - election and removal of directors; - merger or consolidation of our company; and - sale of all or substantially all of our assets. Given the contractual and business relationships between SOFTBANK and us, the interests of SOFTBANK may not always coincide with our interests. SOFTBANK, acting through its designees on the Board of Directors and through its ownership of voting securities, will have the ability to control our actions irrespective of the desires of our other stockholders or directors. YOU WILL EXPERIENCE IMMEDIATE AND SUBSTANTIAL DILUTION IN THE NET TANGIBLE BOOK VALUE OF THE STOCK YOU PURCHASE The initial public offering price of our common stock will be substantially higher than the book value per share of the outstanding common stock after this offering. Therefore, based on an assumed initial offering price of $17.00 per share, if you purchase our common stock in this offering you will suffer immediate dilution of approximately $13.65 per share. If additional shares are sold by the U.S. underwriters following exercise of their over-allotment option, or if outstanding options and warrants to purchase our common stock are exercised, you will experience additional dilution. FOLLOWING THIS OFFERING, SUBSTANTIAL NUMBERS OF SHARES OF OUR COMMON STOCK WILL BECOME AVAILABLE FOR SALE IN THE PUBLIC MARKET, WHICH COULD CAUSE THE MARKET PRICE OF OUR STOCK TO DECLINE Upon completion of this offering, 89,307,159 shares of our common stock will be outstanding, assuming no exercise of the U.S. underwriters' over-allotment option and no exercise of outstanding options or warrants after December 31, 1999. Of these shares, all of the shares sold in this offering will be freely tradable without restriction under the Securities Act, unless purchased by our officers, directors and some of our significant security holders. The remaining 79,307,159 shares of our common stock outstanding as of December 31, 1999 are subject to restrictions under Rule 144 of the Securities Act. Of those shares, substantially all of the shares are subject to a lock-up agreement with the underwriters and will not become eligible for sale in the public market until 180 days following the date of this prospectus, unless earlier released from the lock-up by the underwriters. As restrictions on resale end, the market price of our common stock could drop significantly if the holders of these shares sell them or are perceived by the market as intending to sell them. In addition to the adverse effect a price decline could have on the holders of our common stock, a price decline would likely impede our ability to raise additional capital through the issuance of additional shares of our common stock or other equity securities. Shortly after this offering, we intend to file a registration statement covering 2,000,000 shares of common stock reserved for issuance under our employee stock purchase plan and up to 19,071,213 shares of common stock reserved for issuance under our stock option plans. Any vested shares registered under the registration statement will immediately become available for sale in the open market, subject to the preceding contractual restrictions and, in the case of our officers, directors and some significant security holders, Rule 144 volume limitations. DELAWARE LAW AND OUR CHARTER DOCUMENTS CONTAIN PROVISIONS THAT COULD DISCOURAGE OR PREVENT A POTENTIAL TAKEOVER, EVEN IF THE TRANSACTION WOULD BENEFIT OUR STOCKHOLDERS Other companies may seek to acquire or merge with us. An acquisition or merger of our company could result in benefits to our stockholders, including an increase in the value of our common stock. Some provisions of our Certificate of Incorporation and Bylaws, as well as provisions of Delaware law, may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include: - authorizing the Board of Directors to issue additional preferred stock; - prohibiting cumulative voting in the election of directors; - limiting the persons who may call special meetings of stockholders; - prohibiting stockholder action by written consent; - creating a classified Board of Directors pursuant to which our directors are elected for staggered three year terms; and - establishing advance notice requirements for nominations for election to the Board of Directors and for proposing matters that can be acted on by stockholders at stockholder meetings. OUR MANAGEMENT MAY NOT USE THE PROCEEDS OF THIS OFFERING EFFECTIVELY Our management has broad discretion over the use of proceeds of this offering. In addition, our management has not designated a specific use for a substantial portion of the proceeds of this offering. Accordingly, it is possible that our management may allocate the proceeds differently than investors in this offering would have preferred, or that we fail to maximize our return on the proceeds. ------------------------ IN THIS PROSPECTUS, REFERENCES TO AND STATEMENTS REGARDING CHINA REFER TO THE PEOPLE'S REPUBLIC OF CHINA, EXCLUDING HONG KONG, MACAU AND TAIWAN, REFERENCES TO "U.S. DOLLARS," OR "$" ARE TO UNITED STATES DOLLARS, AND REFERENCES TO "RENMINBI" ARE TO RENMINBI, THE LEGAL CURRENCY OF CHINA. UNLESS SPECIFICALLY STATED, INFORMATION IN THIS PROSPECTUS GIVES EFFECT TO A 2-FOR-1 STOCK SPLIT EFFECTED IN DECEMBER 1999 AND ASSUMES: - AN EXCHANGE RATE OF 8.3 RENMINBI FOR ONE U.S. DOLLAR; - ALL OUTSTANDING SHARES OF OUR PREFERRED STOCK HAVE BEEN CONVERTED ON A ONE-FOR-ONE BASIS INTO AN AGGREGATE OF 70,377,322 SHARES OF COMMON STOCK; AND - THE U.S. UNDERWRITERS WILL NOT EXERCISE THEIR OVER-ALLOTMENT OPTION AND NO OTHER PERSON WILL EXERCISE ANY OTHER OUTSTANDING OPTIONS OR WARRANTS.

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+RISK FACTORS The risks and uncertainties we describe are not the only ones facing us. Additional risks not presently known to us, or that we currently deem immaterial, may also impair our business operations. If any of these risks were to occur, our business, financial condition, or results of operations would likely suffer. In that event, the trading price of our common stock could decline, and you could lose all or part of your investment. Risks Related to our Business If we incur operating losses for longer than we expect, or we are not able to raise additional capital, we may be unable to continue our operations, or we may become insolvent. From our inception through June 30, 2009, we have generated net losses totaling $553.8 million. Our net losses for the six months ended June 30, 2009 and the years ended December 31, 2008, 2007, and 2006 were $21.6 million, $30.8 million, $37.9 million, and $52.8 million, respectively. We expect to incur significant losses over the next several years as we continue research and clinical development of our technologies, apply for regulatory approvals, and pursue commercialization efforts and related activities. Furthermore, our ability to generate cash from operations is dependent on the success of our licensees and collaborative partners, as well as the likelihood and timing of new strategic licensing and partnering relationships and/or successful commercialization of Oncophage and our various product candidates. If we incur operating losses for longer than we expect and/or we are unable to raise additional capital, we may become insolvent and be unable to continue our operations. On June 30, 2009, we had $21.1 million in cash, cash equivalents, and short-term investments. We believe that, based on our current plans and activities, our working capital resources at June 30, 2009, combined with capital raised subsequent to the end of the quarter, anticipated revenues, and the estimated proceeds from our license, supply, and collaborative agreements will be sufficient to satisfy our liquidity requirements into 2011. We expect to attempt to raise additional funds in advance of depleting our current funds. For the six months ended June 30, 2009, our average monthly cash used in operating activities was $2.5 million. We do not anticipate significant capital expenditures during 2009. As part of certain private placement agreements, we are required to maintain effective registration statements. If we are unable to keep the registration statements continuously effective in accordance with the terms of the private placement agreements, we are subject to liquidated damages penalties of up to a maximum of 10% of the aggregate purchase price paid by the original investors, or $6.4 million. Since our inception, we have financed our operations primarily through the sale of equity and convertible notes, interest income earned on cash, cash equivalents, and short-term investment balances, and debt provided through secured lines of credit. In order to finance future operations, we will be required to raise additional funds in the capital markets, through arrangements with collaborative partners, or from other sources. Additional financing may not be available on favorable terms, or at all. If we are unable to raise additional funds when we need them, we will be required to delay, reduce, or eliminate some or all of our development, commercialization and clinical trial programs, including those related to Oncophage. We also may be forced to license or sell technologies to others under agreements that allocate to third parties substantial portions of the potential value of these technologies. We may also be unable to continue our operations, or we may become insolvent. Many economists have indicated that the United States economy, and possibly the global economy, has entered into a prolonged recession. While the ultimate outcome cannot be predicted, this may have a material adverse effect on our liquidity and financial condition, particularly if our ability to raise additional funds is impaired. The ability of potential patients and/or health care payers to pay for Oncophage treatments could also be adversely impacted, thereby limiting our potential revenue. In addition, any negative impacts from the deterioration in the credit markets and related financial crisis on our collaborative partners could limit potential revenue from our product candidates. We have significant long-term debt, and we may not be able to make interest or principal payments when due. As of June 30, 2009, the principal portion of our total long-term debt, excluding the current portion, was $52.1 million. Our 5.25% convertible senior notes due February 2025 (the 2005 Notes ) do not restrict our ability or the ability of our subsidiaries to incur additional indebtedness, including debt that effectively ranks senior to the 2005 Notes. On each of February 1, 2012, February 1, 2015, and February 1, 2020, holders may require us to purchase their notes for cash equal to 100% of the principal amount of the notes, plus any accrued and unpaid interest. Holders may also require us to repurchase their notes upon a fundamental Table of Contents TABLE OF CONTENTS Page Prospectus Summary 1 Risk Factors 2 Cautionary Note Regarding Forward-Looking Statements 17 Use of Proceeds 18 Selling Stockholder 19 Description of Common Stock 21 Plan of Distribution 22 Legal Matters 24 Experts 24 Where You Can Find More Information 24 Incorporation of Certain Information by Reference 24 You should read this prospectus, including all documents incorporated herein by reference, together with additional information described under Where You Can Find More Information. You may obtain the information incorporated by reference without charge by following the instructions under Where You Can Find More Information. All references in this prospectus to Antigenics, the Company, we, us, or our mean Antigenics Inc., unless we state otherwise or the context otherwise requires. You should rely only on the information contained or incorporated by reference in this prospectus. We have not authorized anyone to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. We are not making an offer to sell these securities in any jurisdiction where the offer is not permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or the time of any sale of our common stock. Our business, financial condition, results of operations and prospects may have changed since such date. Table of Contents change, as defined, at a cash price equal to 100% of the principal amount of the notes to be repurchased, plus any accrued and unpaid interest, and in some cases, an additional make-whole premium. At maturity of our 8% senior secured convertible notes due August 2011 (the 2006 Notes ), we may elect to repay the outstanding balance in cash or in common stock, subject to certain limitations. In no event will any of the note holders be obligated to accept equity that would result in them owning in excess of 9.99% of our outstanding common stock at any given time in connection with any conversion, redemption, or repayment of these notes. The 2006 Note agreements include material restrictions on our incurrence of debt and liens while these notes are outstanding, as well as other customary covenants. Our ability to satisfy our obligations will depend upon our future performance, which is subject to many factors, including the factors identified in this Risk Factors section and other factors beyond our control. If we are not able to generate sufficient cash flow from operations in the future to service our indebtedness, we may be required, among other things, to: seek additional financing in the debt or equity markets; refinance or restructure all or a portion of our indebtedness; sell, out-license, or otherwise dispose of assets; and/or reduce or delay planned expenditures on research and development and/or commercialization activities. Such measures might not be sufficient to enable us to make principal and interest payments. In addition, any such financing, refinancing, or sale of assets might not be available on economically favorable terms, if at all. To date, we have had negative cash flows from operations. For the six months ended June 30, 2009 and the years ended December 31, 2008, 2007, and 2006, net cash used in operating activities was $15.1 million, $28.9 million, $26.7 million, and $44.9 million, respectively. Excluding our 2006 Notes, which mature in 2011 and for which we may elect to pay the interest in cash or additional notes, at our option, and for which the outstanding balance at maturity may be paid in cash or in common stock, subject to certain limitations, and assuming no additional interest-bearing debt is incurred and no additional notes are converted, redeemed, repurchased, or exchanged, our cash interest payments will be $1.6 million during 2009 and $1.1 million annually thereafter until maturity. Several factors could delay or prevent the successful commercial launch of Oncophage in Russia. In addition, we do not expect to generate significant revenue from sales of Oncophage in Russia for several months, if ever. In April 2008, the Russian Ministry of Public Health issued a registration certificate for the use of Oncophage for the treatment of kidney cancer patients at intermediate risk for disease recurrence and, in September 2008, the U.S. Food and Drug Administration (the FDA ) granted the necessary permission to allow for the export of Oncophage from the United States to Russia. The Russian registration was our first product approval from a regulatory authority, and the first approval of a patient-specific therapeutic cancer vaccine in a major market. We have obtained an import/export license from the Russian Ministry of Industry and Trade but prior to commercial launch we, or our distributors, must also complete a number of other post-approval activities. Since Oncophage can only be manufactured from a patient s own tumor, patients will need to be diagnosed, and their tumors will need to be removed and sent to our manufacturing facility for vaccine to be prepared, released, and then returned to the site for patient administration. Complexities unique to the logistics of commercial products may delay shipments and limit our ability to move commercial product in an efficient manner without incident. In addition, if we are unable to establish and execute on successful local distribution arrangements including favorable pricing and payment terms, and/or implement appropriate logistical processes for distribution of Oncophage, our commercialization efforts would be adversely affected. Even if we have a successful completion of the logistical and regulatory requirements for Russian launch, the amount of revenue generated from the sale of Oncophage in Russia will depend on, among other things, identifying sources of reimbursement and obtaining adequate reimbursement, including from national or regional funds, and physician and patient assessments of the benefits and cost-effectiveness of Oncophage. If we are unsuccessful in obtaining substantial reimbursement for Oncophage from national or regional funds, we will have to rely on private-pay for the foreseeable future, which may delay or reduce our launch efforts because the ability and willingness of patients to pay is unclear. In addition, cost-containment measures by third parties may prevent us from becoming profitable. Because we have limited resources and minimal sales and marketing experience, commercial launch of Oncophage may be slow. Furthermore, we may experience significant delays in the receipt of payment for Oncophage, or an inability to collect payments at all. If we fail to obtain adequate levels of reimbursement for Oncophage, our product candidates, or the product candidates of our collaborators, there may be no commercially viable market for these products, or the commercial potential of these products may be significantly limited. Table of Contents Public and private insurance programs may determine that Oncophage, our product candidates, or the product candidates of our collaborative partners do not come within a category of items and services covered by their insurance plans. Generally, in Russia, Europe, and other countries outside the United States, government-sponsored health care systems pay a substantial share of health care costs, and they may regulate reimbursement levels of our products to control costs. Government and private third-party payers are increasingly challenging the prices charged for medical products and services, and increasingly attempting to limit and/or regulate the reimbursement for medical products. In many of the markets where we or our collaborative partners would commercialize a product following regulatory approval, the prices of pharmaceutical products are subject to price controls by various mechanisms. Russia is an evolving market and regulatory, legal, and commercial structures are less predictable than in more mature markets. In addition, the reimbursement system in Russia is changing rapidly and has experienced serious funding and administrative problems in its national and regional reimbursement programs. For example, the program known by the Russian acronym of DLO, which was established in January 2005 to provide free-of-charge prescriptions to certain Russians, has substantially delayed payments and covered fewer drugs recently. In addition, the Russian government is attempting to reduce coverage for drugs produced outside of Russia, as they tend to cost more than drugs produced in Russia. Furthermore, it is possible that reimbursement for cancer drugs and other therapeutic areas will not be covered by a newly created system, which may result in uncertainties regarding levels of reimbursement. Drug reimbursement in Russia could continue to undergo change. There can be no assurance regarding the timing, scope, or availability of reimbursement in Russia for Oncophage. If we are unsuccessful in obtaining substantial reimbursement for Oncophage from national or regional funds, we will have to rely on private-pay for the foreseeable future which may delay or prevent our launch efforts, because the ability and willingness of patients to pay is unclear. It is possible that there will be substantial delays in obtaining coverage of Oncophage, our product candidates, or the product candidates of our collaborative partners, if at all, and that, if coverage is obtained, there may be significant restrictions on the circumstances in which there would be reimbursement. Where government or insurance coverage is available, there may be prohibitive levels of patient coinsurance, making products unaffordable, or limits on the payment amount, which could have a material adverse effect on sales. If we are unable to obtain or retain adequate levels of reimbursement from government or private health plans, our or our collaborative partners ability to sell products will be adversely affected. We are unable to predict what impact any future regulation or third-party payer initiatives relating to reimbursement will have on sales. Healthcare reform that may emerge from current policy debate may result in deleterious pricing and potential price controls on pharmaceutical and biotech products in the United States, Europe, and elsewhere. If we fail to comply with regulatory requirements in the countries in which we conduct our business, if these regulatory requirements change, or if we experience unanticipated regulatory problems, our commercial launch of Oncophage could be prevented or delayed, or Oncophage could be subjected to restrictions, or be withdrawn from the market, or some other action may be taken that may be adverse to our business. Regulatory authorities generally approve products for particular indications. If an approval is for a limited indication, this limitation reduces the size of the potential market for that product. Product approvals, once granted, are subject to continual review and periodic inspections by regulatory authorities. Later discovery of previously unknown problems or safety issues and/or failure to comply with applicable regulatory requirements can result in, among other things, warning letters, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, refusal of the government to renew marketing applications, complete withdrawal of a marketing application, and/or criminal prosecution. Such regulatory enforcement could have a direct and negative impact on the product for which approval is granted, but also could have a negative impact on the approval of any pending applications for marketing approval of new drugs or supplements to approved applications. In addition, our operations and marketing practices are subject to regulation and scrutiny by the United States government, as well as governments of any other countries in which we do business or conduct activities. Because we are a company operating in a highly regulated industry, regulatory authorities could take enforcement action against us in connection with our business and marketing activities for various reasons. For example, our marketing and sales, labeling, and promotional activities in Russia are subject to local regulations. If we fail to comply with regulations prohibiting the promotion of products for non-approved indications or products for which marketing approval has not been granted, regulatory authorities could bring enforcement actions against us that could inhibit our marketing capabilities, as well as result in penalties. In addition, the United States Foreign Corrupt Practices Act prohibits U.S. companies and their representatives from offering, promising, authorizing, or making payments to foreign officials for the purpose of obtaining or retaining business abroad. Failure to comply with domestic or foreign laws, knowingly or unknowingly, could result in various adverse consequences, including possible delay in approval or refusal to approve a product, recalls, seizures, withdrawal of an approved product from the market, exclusion from government health care programs, imposition of significant fines, injunctions, and/or the imposition of civil or criminal sanctions against us and/or our officers or employees. Table of Contents From time to time, new legislation is passed into law that could significantly change the statutory provisions governing the approval, manufacturing, and marketing of products regulated by the FDA and other global health authorities. Additionally, regulations and guidance are often revised or reinterpreted by health agencies in ways that may significantly affect our business and our products. It is impossible to predict whether further legislative changes will be enacted, or whether regulations, guidance, or interpretations will change, and what the impact of such changes, if any, may be. We may not be able to obtain approval to market Oncophage in countries other than Russia. Because we expect additional Phase 3 clinical trials of Oncophage may be required prior to submitting a biologics license application ( BLA ) to the FDA for any indication, we likely will not commercialize Oncophage in the United States for several years, if ever. We may face similar hurdles in other territories where we may seek marketing approval. Oncophage is currently only approved for marketing in Russia for the treatment of kidney cancer patients at intermediate risk for disease recurrence. In October 2008, we submitted a marketing authorization application to the European Medicines Agency, or EMEA, requesting conditional authorization of Oncophage in earlier-stage, localized kidney cancer. Conditional authorization, a relatively new provision, is reserved for products intended to treat serious and life-threatening diseases where a high unmet medical need currently exists. Conditional authorization allows for the commercialization of a product with post-approval commitments associated with the requirement to provide comprehensive clinical information about the product s efficacy and safety profile. There is a high level of uncertainty regarding the probability and timing of a favorable outcome. Oncophage may not achieve conditional approval in Europe in 2009, if ever, because we may not successfully address issues associated with post-hoc analysis, subgroup analysis, lack of immunological data, product characterization, or other issues that may be of concern to the EMEA. Additionally, and as resources allow, we continue to explore potential opportunities to seek product approval in other jurisdictions, including the U.S. and Canada. The probability and timing of submissions and/or approval in any jurisdiction or indication for this product is uncertain. The FDA has indicated that our Phase 3 clinical trials of Oncophage cannot, by themselves, support BLA filings in the studies indications (renal cell carcinoma and metastatic melanoma). The signals and trends observed in the Phase 3 renal cell carcinoma and melanoma trials of Oncophage are based on data analysis of subgroups of patients, some of which were not pre-specified. While the subgroup data might be suggestive of treatment effect, under current regulatory guidelines the results cannot be expected, alone, to support registration or approval of Oncophage in the United States, and our existing data may not support registration or approval in other territories outside of Russia, including in Europe. Any additional studies may take years to complete and may fail to support regulatory filings for many reasons. In addition, Oncophage is a novel therapeutic cancer vaccine that is patient-specific, meaning it is derived from the patient s own tumor. The FDA and foreign regulatory agencies, including the European Medicines Agency, which is responsible for product approvals in Europe, and Health Canada, which is responsible for product approvals in Canada, have relatively little experience in reviewing this novel class of patient-specific oncology therapies. Therefore, Oncophage may experience a long regulatory review process and high development costs, either of which could delay or prevent our commercialization efforts. Risks associated with doing business internationally could negatively affect our business. With the registration of Oncophage in Russia, we have begun to focus our efforts on the commercial launch of this product. However, Russia is an evolving market and regulatory, legal, and commercial structures are less predictable than in more mature markets. This unpredictability, combined with changes in Russian leadership, as well as potential geopolitical instability in the Russian region, could negatively impact the regulatory and/or commercial environment there, which in turn could have an adverse effect on our business. In addition, various other risks associated with foreign operations may impact our success. Possible risks include fluctuations in the value of foreign and domestic currencies, disruptions in the import, export, and transportation of patient tumors and our product, the product and service needs of foreign customers, difficulties in building and managing foreign relationships, the performance of our collaborators, and unexpected regulatory, economic, or political changes in foreign markets. Our financial position, results of operations, and cash flows can be affected by fluctuations in foreign currency exchange rates, primarily for the euro and the ruble. Movement in foreign currency exchange rates could cause revenue or clinical trial costs to vary significantly in the future and may affect period-to-period comparisons of our operating results. Historically, we have not hedged our exposure to these fluctuations in exchange rates. Our commercial operations experience and resources are limited and need to be developed or acquired. If we fail to do so, our revenues may be limited or nonexistent. In addition, we may be required to incur significant costs and devote significant efforts to augment our existing capabilities. As we have limited experience with commercial operations, it may be difficult to accurately estimate our costs. We currently do not have employees, manufacturing, or business operations facilities outside of the United States. As we prepare for the commercial Table of Contents launch of Oncophage in Russia, and in the event we obtain conditional authorization of Oncophage in Europe, we will rely significantly on consultants, partners, and other third parties to conduct our sales, marketing, and distribution operations. If these third parties are unable to fulfill their obligations, our commercial launch of Oncophage could be delayed or prevented. If in the future we elect to perform sales, marketing, and distribution functions ourselves, we will face a number of additional risks, including the need to recruit experienced marketing and sales personnel, or incur significant expenditures. In addition, we may need to compete with other companies that have more experienced and better-funded operations. Where we have licensed our products to third-party collaborators or licensees, we will be dependent on their commercial operations, sales and marketing expertise and resources, and any revenues we receive from those products will depend primarily on the sales and marketing efforts of others. For Oncophage, we need to develop specialized commercial operations to manage patient-specific ordering, tracking, and control. There are few companies that have developed this expertise and we do not know whether we will be able to establish commercial operations or enter into marketing and sales agreements with others on acceptable terms, if at all. Our competitors in the biotechnology and pharmaceutical industries may have superior products, manufacturing capability, and/or selling and marketing expertise. Our business and the products in development by our collaborative partners may fail because of intense competition from major pharmaceutical companies and specialized biotechnology companies engaged in the development of product candidates directed at cancer, infectious diseases and degenerative disorders. Several of these companies have products that utilize technologies similar to Oncophage and/or patient-specific medicine techniques, such as Dendreon, Oxford BioMedica and its partner Sanofi-Aventis, Nventa (formerly Stressgen), Accentia, and Cell Genesys. Patents have been issued in both the United States and Europe related to Nventa s heat shock protein technology. There is no guarantee that we will be able to compete with potential future products being developed by our competitors. More specifically, Oncophage may compete with therapies currently in development for non-metastatic renal cell carcinoma, such as Wilex AG s Rencarex (WX-G250), which is in Phase 3 clinical trials. Additionally, sorafenib and sunitinib, which are approved for advanced renal cell carcinoma, are being studied in non-metastatic renal cell carcinoma, and other products that have been developed for metastatic renal cell carcinoma, such as temsirolimus and bevacizumab, may also be developed for non-metastatic renal cell carcinoma. As Oncophage is potentially developed in other indications, it will face additional competition in those indications. In addition, for Oncophage and all of our product candidates, prior to regulatory approval, we may compete for access to patients with other products in clinical development, with products approved for use in the indications we are studying, or with off-label use of products in the indications we are studying. Our product candidate, Aroplatin, may compete with existing approved chemotherapies or other chemotherapies that are in development by various companies, including GPC Biotech and Poniard Pharmaceuticals. We anticipate that we will face increased competition in the future as new companies enter markets we seek to address and scientific developments surrounding immunotherapy and other traditional cancer therapies continue to accelerate. Our patent to purified QS-21 expired in most territories in 2008. Additional protection for our QS-21 proprietary adjuvant in combination with other agents is provided by our other patents. Our license and supply agreements for QS-21 would typically provide royalties for at least 10 years after commercial launch. However, there is no guarantee that we will be able to collect royalties in the future. Several other vaccine adjuvants are in development and could compete with QS-21 for inclusion in vaccines in development. These adjuvants include, but are not limited to, oligonucleotides, under development by Pfizer, Idera, Juvaris, and Dynavax, anti-CTLA-4 antibody, under development by Pfizer and Bristol-Myers Squibb, MF59 and SAF, under development by Novartis, IC31, under development by Intercell, and MPL, under development by GlaxoSmithKline ( GSK ). In addition, several companies, such as CSL Limited and Galenica, as well as academic institutions, are developing saponin adjuvants, including derivatives and synthetic formulations. Many of our competitors, including large pharmaceutical companies, have greater financial and human resources and more experience than we do. Our competitors may: commercialize their product candidates sooner than we commercialize our own; develop safer or more effective therapeutic drugs or preventive vaccines and other therapeutic products; implement more effective approaches to sales and marketing and capture some of our potential market share; establish superior intellectual property positions; discover technologies that may result in medical insights or breakthroughs, which render our drugs or vaccines obsolete, possibly before they generate any revenue; or adversely affect our ability to recruit patients for our clinical trials. Table of Contents Manufacturing problems may cause product launch delays, unanticipated costs, or loss of revenue streams. If one of our product candidates or our licensees product candidates for which we maintain exclusive or primary manufacturing rights for a component nears marketing approval or is approved for sale, or if the Russian market for Oncophage is substantially greater than we anticipate, or if we obtain approval or conditional approval for Oncophage in another territory, we may be required to manufacture substantially more than we have been required to manufacture for preclinical studies and clinical trials. We have no experience manufacturing products in commercial quantities, and we can provide no assurance that we will be able to do so successfully. We may experience higher manufacturing failure rates than we have in the past if and when we attempt to substantially increase production volume. We currently manufacture Oncophage in our Lexington, Massachusetts facility. We intend to use this facility to manufacture Oncophage for the Russian market, as well as for ongoing and future clinical trials. While we believe we will be able to cover both our commercial and clinical Oncophage demands in the near term, there is no guarantee that we will be able to meet any unanticipated increase in demand, and a failure to do so could adversely affect our business. An unanticipated increase in the demand for the commercial supply of Oncophage could result in our inability to meet commercial demand or to manufacture sufficient Oncophage product to support our clinical trials, and this could cause a delay or failure in our Oncophage programs. Manufacturing of Oncophage is complex, and various factors could cause delays or an inability to supply vaccine. Oncophage is a patient-specific biologic and requires product characterization steps that are more onerous than those required for most chemical pharmaceuticals. Accordingly, we employ multiple steps to attempt to control the manufacturing processes. Deviations in these manufacturing processes could result in production failures. We can also manufacture other clinical product in our own manufacturing facility. This manufacturing facility has certain support areas that it shares with the Oncophage manufacturing areas. As we seek to expand the market opportunities for Oncophage, including possibly filing for approvals in other territories, the applicable regulatory bodies may require us to make our Oncophage manufacturing facility a single product facility. In such an instance, we would no longer have the ability to manufacture AG-707 in our current facility. AG-707 is a complex product requiring Good Manufacturing Practices, or GMP, for the manufacture and release of a recombinant protein and a large number of peptides. In order to prepare additional AG-707 to support future clinical trials, we will have to manufacture or have manufactured these critical raw materials in a GMP compliant facility. Currently, we do not manufacture QS-21 in our own manufacturing facility. If we choose to manufacture QS-21 in our own manufacturing facility, the investment of substantial funds and the recruitment of qualified personnel would be required in order to build and/or lease and operate new manufacturing facilities. While we have previously relied on a third-party manufacturer to meet QS-21 supply demands, that supplier currently does not, and may never have the ability to, manufacture commercial grade QS-21. Our ability to use GSK as a supplier to meet our other QS-21 licensees needs is limited and not desirable to all of our QS-21 licensees. In order to continue to support QS-21 product candidates, apply for regulatory approvals, and commercialize this product candidate, we or our licensees or collaborators will need to develop, contract for, or otherwise arrange for the necessary manufacturing capabilities. There is no assurance that we or our licensees or collaborators will be successful in these endeavors. If we fail to comply with our obligations in our supply agreements with third parties, we could lose revenue streams that are important to our business. We also do not currently manufacture Aroplatin in our own manufacturing facility. We have previously relied on third-party manufacturers to meet our Aroplatin development needs and if we do continue our development program of this product we will need to develop, contract for or otherwise arrange for the necessary manufacturing resources. We currently rely upon and expect to continue to rely upon third parties, potentially including our collaborators or licensees, to produce materials required for product candidates, preclinical studies, clinical trials, and commercialization. A number of factors could cause production interruptions at our manufacturing facility or at our contract manufacturers, including equipment malfunctions, labor or employment retention problems, natural disasters, power outages, terrorist activities, or disruptions in the operations of our suppliers. Alternatively, there is the possibility we may have excess manufacturing capacity if product candidates do not progress as planned. There are a limited number of contract manufacturers that operate under applicable GMP regulations that are capable of manufacturing our product candidates. If we are unable to do so ourselves or to arrange for third-party manufacturing of these product candidates, or to do so on commercially reasonable terms, we may not be able to complete development of these product candidates or commercialize them ourselves or through our collaborative partners or licensees. Reliance on third-party manufacturers entails risks to which we would not be subject if we manufactured products ourselves, including reliance on the third party for regulatory compliance, the possibility of breach of the manufacturing agreement by the third party because of factors beyond our control, and the possibility of termination or non-renewal of the agreement by the third party, based on its own business priorities, at a time that is costly or inconvenient for us. Table of Contents Manufacturing is also subject to extensive government regulation. Regulatory authorities must approve the facilities in which human health care products are produced. In addition, facilities are subject to ongoing inspections, and minor changes in manufacturing processes may require additional regulatory approvals, either of which could cause us to incur significant additional costs and lose revenue. The drug development and approval process is uncertain, time-consuming, and expensive. The process of obtaining and maintaining regulatory approvals for new therapeutic products is lengthy, expensive, and uncertain. It also can vary substantially based on the type, complexity, and novelty of the product. We must provide regulatory authorities with preclinical and clinical data demonstrating that our product candidates are safe and effective before they can be approved for commercial sale. Clinical development, including preclinical testing, is also a long, expensive, and uncertain process. It may take us several years to complete our testing, and failure can occur at any stage of testing. Interim results of preclinical studies or clinical trials do not necessarily predict their final results, and acceptable results in early studies might not be seen in later studies. Any preclinical or clinical test may fail to produce results satisfactory to regulatory authorities for many reasons, including but not limited to study structure, conduct, failure to enroll a sufficient number of patients, and collectability of data. Preclinical and clinical data can be interpreted in different ways, which could delay, limit, or prevent regulatory approval. Negative or inconclusive results from a preclinical study or clinical trial, adverse medical events during a clinical trial, or safety issues resulting from products of the same class of drug could require a preclinical study or clinical trial to be repeated or cause a program to be terminated, even if other studies or trials relating to the program are successful. As of June 30, 2009, we have spent approximately 15 years and $264.6 million on our research and development program in heat shock proteins for cancer. We may not complete our planned preclinical studies or clinical trials on schedule or at all. We may not be able to confirm the safety and efficacy of our potential drugs in long-term clinical trials, which may result in further delays or failure to commercialize our product candidates. The timing and success of a clinical trial is dependent on enrolling sufficient patients in a timely manner, avoiding serious or significant adverse patient reactions, and demonstrating efficacy of the product candidate in order to support a favorable risk versus benefit profile, among other considerations. Because we rely on third-party clinical investigators and contract research organizations to conduct our clinical trials, we may encounter delays outside our control, particularly if our relationships with any third-party clinical investigators or contract research organizations are adversarial. The timing and success of our clinical trials, in particular, are also dependent on clinical sites and regulatory authorities accepting each trial s protocol, statistical analysis plan, product characterization tests, and clinical data. If we are unable to satisfy clinical sites or regulatory authorities with respect to such matters, including the specific matters noted above, or our clinical trials yield inconclusive or negative results, we will be required to modify or expand the scope of our clinical studies or conduct additional studies to support marketing approvals, or modify our development pipeline. In addition, regulatory authorities may request additional information or data that is not readily available. Delays in our ability to respond to such requests would delay, and failure to adequately address concerns would prevent, our commercialization efforts. Also, we or regulatory authorities might further delay or halt our clinical trials for various reasons, including but not limited to: we may fail to comply with extensive regulations; a product candidate may not appear to be more effective than current therapies; a product candidate may have unforeseen, undesirable, or significant adverse side effects, toxicities, or other characteristics; we may fail to prospectively identify, or identify at all, the most appropriate patient populations and/or statistical analyses for inclusion in our clinical trials; the time required to determine whether a product candidate is effective may be longer than expected; we may be unable to adequately follow or evaluate patients after treatment with a product candidate; patients may die during a clinical trial because their disease is too advanced or because they experience medical problems that may not be related to the product candidate; sufficient numbers of patients may not meet our eligibility criteria and/or enroll in our clinical trials and may withdraw from our clinical trials after they have enrolled; or we may be unable to produce sufficient quantities of a product candidate to complete the trial. Furthermore, regulatory authorities, including the FDA and the European Medicines Agency, may have varying interpretations of our preclinical study and clinical trial data, which could delay, limit, or prevent regulatory approval or clearance. Any delays or difficulties in obtaining regulatory approvals or clearances for our product candidates may: adversely affect the marketing of any products we or our collaborators develop; Table of Contents impose significant additional costs on us or our collaborators; diminish any competitive advantages that we or our collaborators may attain; limit our ability to receive royalties and generate revenue and profits; and adversely affect our business prospects and ability to obtain financing. If we are delayed in these activities or do not receive regulatory approval for our product candidates in a timely manner, we may have to incur additional development expense, and subject to securing additional financing, we will not be able to commercialize them in the timeframe anticipated, and therefore our business will suffer. New data from our research and development activities could modify our strategy and result in the need to adjust our projections of timelines and costs of programs. Because we are focused on novel technologies, our research and development activities, including our preclinical studies and clinical trials, involve the ongoing discovery of new facts and the generation of new data, based on which we determine next steps for a relevant program. These developments are sometimes a daily occurrence and constitute the basis on which our business is conducted. We need to make determinations on an ongoing basis as to which of these facts or data will influence timelines and costs of programs. We may not always be able to make such judgments accurately, which may increase the costs we incur attempting to commercialize our product candidates. These issues are pronounced in our efforts to commercialize Oncophage, which represents an unprecedented approach to the treatment of cancer. We may need to successfully address a number of technological challenges in order to complete development of our product candidates. Moreover, these product candidates may not be effective in treating any disease or may prove to have undesirable or unintended side effects, toxicities, or other characteristics that may preclude our obtaining regulatory approvals or prevent or limit commercial use. Failure to enter into significant collaboration agreements may hinder our efforts to develop and commercialize our product candidates and will increase our need to rely on other financing mechanisms, such as sales of securities, to fund our operations. We have been engaged in efforts to enter into collaborative agreements with one or more pharmaceutical or larger biotechnology companies to assist us with development and/or commercialization of our product candidates. If we are successful in entering into a collaborative agreement we may not be able to negotiate agreements with economic terms similar to those negotiated by other companies. We may not, for example, obtain significant up-front payments or substantial royalty rates. If we fail to enter into collaboration agreements, our efforts to develop and/or commercialize our products or product candidates may be undermined. In addition, if we do not raise funds through collaboration agreements, we will need to rely on other financing mechanisms, such as sales of securities, to fund our operations. Sales of certain securities may substantially dilute the ownership of existing stockholders. If we are unable to complete the sale of such securities, we may become insolvent. While we have been pursuing these business development efforts for several years, we have not entered into an agreement relating to the potential development or commercialization of Oncophage. Due to the announcement in March 2006 that part I of our Phase 3 trial in renal cell carcinoma did not achieve its primary endpoint in the intent to treat population, and because companies may be skeptical regarding the potential success of a patient-specific product candidate, many companies may be unwilling to commit to an agreement prior to receipt of additional clinical data, if at all. In the absence of such data, potential collaborative partners may demand economic terms that are unfavorable to us, or may be unwilling to collaborate with us at all. Even if Oncophage generates favorable clinical data over the next several years, we may not be able to negotiate a collaborative transaction at all, or negotiate one that provides us with favorable economic terms. In addition, we would consider license and/or co-development opportunities to advance Aroplatin and AG-707. These products are at an early stage, and collaborative partners or licensees may defer discussions until results from early clinical trials become available, or they may not engage in such discussions at all. Further work on these programs is on hold due to cost-containment efforts. Because we rely on collaborators and licensees for the development and commercialization of some of our product candidate programs, these programs may not prove successful, and/or we may not receive significant payments from such parties. Part of our strategy is to develop and commercialize some of our product candidates by continuing our existing arrangements with academic and corporate collaborators and licensees and by entering into new collaborations. Our success depends on our ability to negotiate such agreements and on the success of the other parties in performing research, preclinical and clinical testing, completing regulatory applications, and commercializing product candidates. For example, the development of Oncophage for the treatment of glioma is currently dependent in large part on the efforts of our institutional collaborators, such as the Brain Tumor Research Center at the University of California, San Francisco, which is conducting a Phase 2 clinical trial of Oncophage for the Table of Contents treatment of recurrent glioma. In addition, all product candidates containing QS-21 depend on the success of our collaborative partners or licensees, and the Company s relationships with these third parties. Such product candidates depend on the successful and adequate manufacture and/or supply of QS-21, and our collaborators and licensees successfully enrolling patients and completing clinical trials, being committed to dedicating the resources to advance these product candidates, obtaining regulatory approvals, and successfully commercializing product candidates. These development activities may fail to produce marketable products due to unsuccessful results or abandonment of these programs, failure to enter into future collaborations or license agreements, or the inability to manufacture product supply requirements for our collaborators and licensees. For example, in August 2006, Pharmexa A/S announced a decision to cease dosing patients in their Phase 2 clinical trial of their HER-2 Protein AutoVac breast cancer vaccine containing our QS-21 adjuvant, after it was determined that the trial was unlikely to meet its primary endpoint. Several of our agreements also require us to transfer important rights and regulatory compliance responsibilities to our collaborators and licensees. As a result of collaborative agreements, we will not control the nature, timing, or cost of bringing these product candidates to market. Our collaborators and licensees could choose not to devote resources to these arrangements or, under certain circumstances, may terminate these arrangements early. They may cease pursuing product candidates or elect to collaborate with different companies. In addition, these collaborators and licensees, outside of their arrangements with us, may develop technologies or products that are competitive with those that we are developing. From time to time, we may also become involved in disputes with our collaborators. Such disputes could result in the incurrence of significant expense, or the termination of collaborations. We may be unable to fulfill all of our obligations to our collaborators, which may result in the termination of collaborations. As a result of these factors, our strategic collaborations may not yield revenue. Furthermore, we may be unable to enter into new collaborations or enter into new collaborations on favorable terms. Failure to generate significant revenue from collaborations would increase our need to fund our operations through sales of securities and would negatively affect our business prospects. If we are unable to purify heat shock proteins from some cancer types, we may have difficulty successfully initiating clinical trials in new indications or completing our clinical trials, and, even if we do successfully complete our clinical trials, the size of our potential market could decrease. Our ability to successfully develop and commercialize Oncophage for a particular cancer type depends in part on our ability to purify heat shock proteins from that type of cancer. If we experience difficulties in purifying heat shock proteins for a sufficiently large number of patients in our clinical trials, it may lower the probability of a successful analysis of the data from these trials and, ultimately, the ability to obtain regulatory approvals. For example, our inability to manufacture adequate amounts of Oncophage for approximately 30% of the patients randomized in the Oncophage treatment arm of the Phase 3 metastatic melanoma trial undermined the potential for the trial to meet its pre-specified clinical endpoints. To address this lower success rate for melanoma, we included additional protease inhibitors in the manufacturing process to further limit the breakdown of the product. Subsequent to the implementation of this change, we successfully produced Oncophage for 18 of 23 patients, a success rate of approximately 78%, whereas previously we had produced Oncophage for 123 of 179 patients, a success rate of approximately 69%. The small sample size used subsequent to our process change may make the reported improvement in our manufacturing success unreliable as a predictor of future success. We have successfully manufactured product for 100%, 10 of 10, of the patients randomized to treatment in our Phase 2 lung cancer trial and 95%, 21 of 22, of the patients randomized to treatment in our Phase 2 metastatic renal cell carcinoma trial. Based on our clinical trials to date, we have been able to manufacture Oncophage from 87% of the tumors delivered to our manufacturing facility in Lexington, Massachusetts; for non-metastatic renal cell carcinoma, 92%; for melanoma, 70%; for colorectal cancer, 98%; for gastric cancer, 81%; for lymphoma, 89%; for glioma, 84%; and for pancreatic cancer, 46%. The relatively low rate of manufactured product for pancreatic cancer is due to the abundance of proteases in pancreatic tissue. Proteases, which are enzymes that break down proteins, are believed to degrade the heat shock proteins during the purification process. We may encounter problems with other types of cancer as we expand our research. If we cannot overcome these problems, the number of cancer types that our heat shock protein product candidates could treat would be limited. In addition, if we commercialize our heat shock protein product candidates, we may not be able to replicate past manufacturing success rates and we may face claims from patients for whom we are unable to produce a vaccine. If we fail to sustain and further build our intellectual property rights, competitors will be able to take advantage of our research and development efforts to develop competing products. If we are not able to protect our proprietary technology, trade secrets, and know-how, our competitors may use our inventions to develop competing products. We currently have exclusive rights to 75 issued United States patents and 95 foreign patents. We also have exclusive rights to 16 pending United States patent applications and 69 pending foreign patent applications. However, we currently do not have any issued patents in Russia covering Oncophage and we may not have rights to Oncophage patents in other territories where we may pursue regulatory approval. In addition, our patents may not protect us against our competitors. Our patent Table of Contents positions, and those of other pharmaceutical and biotechnology companies, are generally uncertain and involve complex legal, scientific, and factual questions. The standards which the United States Patent and Trademark Office uses to grant patents, and the standards which courts use to interpret patents, are not always applied predictably or uniformly and can change, particularly as new technologies develop. Consequently, the level of protection, if any, that will be provided by our patents if we attempt to enforce them, and they are challenged, is uncertain. In addition, the type and extent of patent claims that will be issued to us in the future is uncertain. Any patents that are issued may not contain claims that permit us to stop competitors from using similar technology. In addition to our patented technology, we also rely on unpatented technology, trade secrets, and confidential information. We may not be able to effectively protect our rights to this technology or information. Other parties may independently develop substantially equivalent information and techniques or otherwise gain access to or disclose our technology. We generally require each of our employees, consultants, collaborators, and certain contractors to execute a confidentiality agreement at the commencement of an employment, consulting, collaborative, or contractual relationship with us. However, these agreements may not provide effective protection of our technology or information, or in the event of unauthorized use or disclosure, they may not provide adequate remedies. We may incur substantial costs as a result of litigation or other proceedings relating to patent and other intellectual property rights, and we may be unable to protect our rights to, or use, our technology. If we choose to go to court to stop someone else from using the inventions claimed in our patents, that individual or company has the right to ask a court to rule that our patents are invalid and should not be enforced against that third party. These lawsuits are expensive and would consume time and other resources even if we were successful in stopping the infringement of our patents. In addition, there is a risk that the court will decide that our patents are not valid and that we do not have the right to stop the other party from using the claimed inventions. There is also the risk that, even if the validity of our patents is upheld, the court will refuse to stop the other party on the grounds that such other party s activities do not infringe our patents. We may not have rights under some patents or patent applications related to some of our existing and proposed products or processes. Third parties may own or control these patents and patent applications in the United States and abroad. Therefore, in some cases, such as those described below, in order to develop, use, manufacture, sell, or import some of our existing or proposed products, or develop or use some of our existing or proposed processes, we or our collaborators may choose to seek, or be required to seek, licenses under third-party patents issued in the United States and abroad, or those that might issue from United States and foreign patent applications. In such an event, we likely would be required to pay license fees or royalties or both to the licensor. If licenses are not available to us on acceptable terms, we or our collaborators may not be able to exploit these products or processes. Furthermore, a third party may claim that we are using inventions covered by such third-party s patents or other intellectual property rights and may go to court to stop us from engaging in our normal operations and activities. These lawsuits are expensive and would consume time and other resources. There is a risk that a court would decide that we are infringing the third-party s patents and would order us to stop the activities covered by the patents. In addition, there is a risk that a court will order us to pay the other party substantial damages for having violated the other party s patents. The biotechnology industry has produced a proliferation of patents, and it is not always clear to industry participants, including us, which patents cover various types of products. The coverage of patents is subject to interpretation by the courts, and the interpretation is not always uniform. We know of patents issued to third parties relating to heat shock proteins and alleviation of symptoms of cancer. We have reviewed these patents, and we believe, as to each claim in those patents, that we either do not infringe the claim, or that the claim is invalid. Moreover, patent holders sometimes send communications to a number of companies in related fields suggesting possible infringement, and we, like a number of biotechnology companies, have received such communications, including with respect to the third-party patents mentioned above, as well as communications alleging infringement of a patent relating to certain gel-fiberglass structures. If we are sued for patent infringement, we would need to demonstrate that our products either do not infringe the patent claims of the relevant patent and/or that the patent claims are invalid, which we may not be able to do. Proving invalidity, in particular, is difficult, since it requires a showing of clear and convincing evidence to overcome the presumption of validity enjoyed by issued patents. We may become involved in expensive patent litigation or other proceedings, which could result in our incurring substantial costs and expenses or substantial liability for damages, or require us to stop development and commercialization efforts. There has been substantial litigation and other proceedings regarding patent and other intellectual property rights in the pharmaceutical and biotechnology industries. We may become a party to patent litigation or other proceedings regarding intellectual property rights. The cost to us of any patent litigation or other proceeding, even if resolved in our favor, could be substantial. Some of our competitors may be able to sustain the cost of such litigation or proceedings more effectively than we can because of their Table of Contents substantially greater financial resources. If patent litigation or other proceeding is resolved against us, we or our collaborators may be enjoined from using, manufacturing, selling, or importing our products or processes without a license from the other party, and we may be held liable for significant damages. We may not be able to obtain any required licenses on commercially acceptable terms or at all. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to enter into collaborations with other entities, obtain financing, or compete in the marketplace. Patent litigation and other proceedings may also absorb significant management time. Our patent protection for any compound or product that we seek to develop may be limited to a particular method of use or indication such that, if a third party were to obtain approval of the compound or product for use in another indication, we could be subject to competition arising from off-label use. The patent landscape in our business is becoming increasingly congested with competing applications for protection of closely related compounds and technologies that arise from both industrial and academic research. Although we generally seek the broadest patent protection available for our proprietary compounds, competing art may prevent us from obtaining patent protection for the actual composition of matter of any particular compound and we may be limited to protecting a new method of use for the compound or otherwise restricted in our ability to prevent others from exploiting the compound. If we are unable to obtain patent protection for the actual composition of matter of any compound that we seek to develop and commercialize and must rely on method of use patent coverage, we would likely be unable to prevent others from manufacturing or marketing that compound for any use that is not protected by our patent rights. If a third party were to receive marketing approval for the compound for another use, physicians might nevertheless prescribe it for indications that are not described in the product s labeling or approved by the FDA or other regulatory authorities. Even if we have patent protection of the prescribed indication, as a practical matter, we likely would have little recourse as a result of this off-label use. In that event, our revenues from the commercialization of the compound would likely be adversely affected. If we fail to comply with our obligations in our intellectual property licenses with third parties, we could lose license rights that are important to our business. We are a party to various license agreements under which we receive the right to practice and use important third-party patent rights and we may enter into additional licenses in the future. Our existing licenses impose, and we expect future licenses will impose, various diligence, milestone payment, royalty, insurance, and other obligations on us. If we fail to comply with these obligations, the licensor may have the right to terminate the license, in which event we might not be able to market any product that is covered by the licensed patents. If we fail to retain the services of, and/or maintain positive relations with, key individuals and our employees, we may be unable to successfully develop our product candidates, conduct clinical trials, and obtain financing. Garo H. Armen, Ph.D., the Chairman of our Board of Directors and our Chief Executive Officer, co-founded Antigenics in 1994 with Pramod K. Srivastava, Ph.D., and has been and continues to be integral to building our company and developing our technology. If Dr. Armen severed his relationship with Antigenics, our business may be adversely impacted. Effective December 1, 2005, we entered into an employment agreement with Dr. Armen. Subject to the earlier termination as provided in the agreement, the agreement had an original term of one year and is automatically extended thereafter for successive terms of one year each, unless either party provides notice to the other at least ninety days prior to the expiration of the original or any extension term. Dr. Armen plays an important role in our day-to-day activities. We do not carry key employee insurance policies for Dr. Armen or any other employee. Dr. Srivastava currently has a consulting agreement with us pursuant to which he is retained to provide advice and services to Antigenics from time to time. This agreement has an initial term ending March 31, 2011. We also rely greatly on employing and retaining other highly trained and experienced senior management and scientific and operations personnel. The competition for these and other qualified personnel in the biotechnology field is intense. In order to reduce our expenses, we have eliminated certain employee benefits, restructured our business, and reduced staffing levels. This restructuring has in many cases eliminated any redundancy in skills and capabilities in key areas. If we are not able to attract and retain qualified personnel, we may not be able to achieve our strategic and operational objectives. We may face litigation that could result in substantial damages and may divert management s time and attention from our business. Antigenics, our Chairman and Chief Executive Officer, Garo H. Armen, Ph.D., and two investment banking firms that served as underwriters in our initial public offering have been named as defendants in a federal civil class action lawsuit pending in the United States District Court for the Southern District of New York. Substantially similar actions were filed concerning the initial public Table of Contents offerings for more than 300 different issuers, and the cases were coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92 for pre-trial purposes. The suit alleges that the brokerage arms of the investment banking firms charged secret excessive commissions to certain of their customers in return for allocations of our stock in the offering. The suit also alleges that shares of our stock were allocated to certain of the investment banking firms customers based upon agreements by such customers to purchase additional shares of our stock in the secondary market. Dr. Armen has been dismissed without prejudice from the lawsuit pursuant to a stipulation. In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us, was submitted to the Court for approval. The Court preliminarily approved the settlement in August 2005. In December 2006, the appellate court overturned the certification of classes in six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceedings. The case involving Antigenics is not one of the six test cases. Class certification had been one of the conditions of the settlement. Accordingly, on June 25, 2007, the Court entered an order terminating the proposed settlement based on a stipulation among the parties to the settlement. Plaintiffs have filed amended master allegations and amended complaints in the six test cases. On March 26, 2008, the Court largely denied the defendants motion to dismiss the amended complaints. The parties recently reached a global settlement of the litigation. On April 2, 2009, plaintiffs filed a motion for preliminary approval of the settlement. Under the settlement, which the Court preliminarily approved on June 9, 2009, the insurers would pay the full amount of settlement share allocated to the defendants, and the defendants would bear no financial liability. The company defendants, as well as the officer and director defendants who were previously dismissed from the action pursuant to tolling agreements, would receive complete dismissals from the case. It is uncertain whether the settlement will receive final Court approval. Regardless of the outcome, participation in this lawsuit diverts our management s time and attention from our business and may result in our paying damages. In addition, we are involved in other litigation and may become involved in additional litigation. Any such litigation could be expensive in terms of out-of-pocket costs and management time, and the outcome of any such litigation is uncertain. Our directors and officers insurance policies provide $25.0 million annual aggregate coverage and $25.0 million per occurrence coverage. This limited insurance coverage may not be sufficient to cover us for future claims. Product liability and other claims against us may reduce demand for our products and/or result in substantial damages. We face an inherent risk of product liability exposure related to testing our product candidates in human clinical trials and will face even greater risks upon the sale of Oncophage commercially, as well as if we sell our various product candidates commercially. An individual may bring a product liability claim against us if Oncophage or one of our product candidates causes, or merely appears to have caused, an injury. Product liability claims may result in: decreased demand for Oncophage or our product candidates; injury to our reputation; withdrawal of clinical trial volunteers; costs of related litigation; and substantial monetary awards to plaintiffs. We manufacture Oncophage from a patient s cancer cells, and a medical professional must inject Oncophage into the same patient from which it was manufactured. A patient may sue us if a hospital, a shipping company, or we fail to deliver the removed cancer tissue or that patient s Oncophage. We anticipate that the logistics of shipping will become more complex if the number of patients we treat increases and that shipments of tumor and/or Oncophage may be lost, delayed, or damaged. Additionally, complexities unique to the logistics of commercial products may delay shipments and limit our ability to move commercial product in an efficient manner without incident. Currently, we do not have insurance that covers loss of or damage to Oncophage or tumor material, and we do not know whether such insurance will be available to us at a reasonable price or at all. We have limited product liability coverage for use of our product candidates. Our product liability policy provides $10.0 million aggregate coverage and $10.0 million per occurrence coverage. This limited insurance coverage may be insufficient to fully cover us for future claims. If we do not comply with environmental laws and regulations, we may incur significant costs and potential disruption to our business. We use hazardous, infectious, and radioactive materials, and recombinant DNA in our operations, which have the potential of being harmful to human health and safety or the environment. We store these hazardous (flammable, corrosive, toxic), infectious, and radioactive materials, and various wastes resulting from their use, at our facilities pending use and ultimate disposal. We are subject to a variety of federal, state, and local laws and regulations governing use, generation, storage, handling, and disposal of these materials. We may incur significant costs complying with both current and future environmental health and safety laws and regulations. In particular, we are subject to regulation by the Occupational Safety and Health Administration, the Environmental Protection Agency, the Drug Enforcement Agency, the Department of Transportation, the Centers for Disease Control and Prevention, the National Institutes of Health, the International Air Transportation Association, and various state and local agencies. At Table of Contents any time, one or more of the aforementioned agencies could adopt regulations that may affect our operations. We are also subject to regulation under the Toxic Substances Control Act and the Resource Conservation Development programs. Although we believe that our current procedures and programs for handling, storage, and disposal of these materials comply with federal, state, and local laws and regulations, we cannot eliminate the risk of accidents involving contamination from these materials. Although we have limited pollution liability coverage ($2.0 million) and a workers compensation liability policy, we could be held liable for resulting damages in the event of an accident or accidental release, and such damages could be substantially in excess of any available insurance coverage and could substantially disrupt our business. Risks Related to our Common Stock Our officers and directors may be able to block proposals for a change in control. Antigenics Holdings LLC is a holding company that owns shares of our common stock, and as of June 30, 2009, Antigenics Holdings LLC controlled approximately 14% of our outstanding common stock. Due to this concentration of ownership, Antigenics Holdings LLC can substantially influence all matters requiring a stockholder vote, including: the election of directors; the amendment of our organizational documents; or the approval of a merger, sale of assets, or other major corporate transaction. Our Chief Executive Officer directly and indirectly owns approximately 48% of Antigenics Holdings LLC. In addition, several of our directors and officers directly and indirectly own approximately 4% of our outstanding common stock. The unaffiliated holders of certain convertible securities have the right to convert such securities into a substantial percentage of our outstanding common stock. According to publicly filed documents, Mr. Brad M. Kelley beneficially owns 5,546,240 shares of our outstanding common stock and 31,620 shares of our series A convertible preferred stock. The shares of preferred stock are currently convertible at any time into 2,000,000 shares of common stock at an initial conversion price of $15.81, are non-voting, and carry a 2.5% annual dividend yield. If Mr. Kelley had converted all of the shares of preferred stock on June 30, 2009, he would have held approximately 9% of our outstanding common stock. We currently have a right of first refusal agreement with Mr. Kelley that provides us with limited rights to purchase certain of Mr. Kelley s shares if he proposes to sell them to a third party. Mr. Kelley s substantial ownership position provides him with the ability to substantially influence the outcome of matters submitted to our stockholders for approval. Furthermore, collectively, Mr. Kelley and Antigenics Holdings LLC control approximately 21% of our outstanding common stock as of June 30, 2009, providing substantial ability, if they vote in the same manner, to determine the outcome of matters submitted to a stockholder vote. If Mr. Kelley were to convert all of his preferred stock into common stock, the combined total would increase to 23%. Additional purchases of our common stock by Mr. Kelley also would increase both his percentage of outstanding voting rights and the percentage combined with Antigenics Holdings LLC. While Mr. Kelley s shares of preferred stock do not carry voting rights, the shares of common stock issuable upon conversion carry the same voting rights as other shares of common stock. On October 30, 2006, we issued $25.0 million of our 2006 Notes to a group of institutional investors. These 2006 Notes, together with any interest paid in the form of additional 2006 Notes, are convertible into our common stock at an initial fixed conversion price of $3.50 per share at the option of the investors. On June 30, 2009, one holder of the 2006 Notes had holdings which, if totally converted into shares of our common stock, would result in this holder owning 7,045,000 shares. If such holder had exercised such conversion right on June 30, 2009, such holder would have owned approximately 8% of our outstanding common stock. While the 2006 Notes do not carry any voting rights, the common stock issuable upon conversions of such securities do carry the same voting rights as other shares of common stock. The ownership positions following any such conversions, along with any open market purchases by such holders, could provide the holders with the ability to substantially influence the outcome of matters submitted to our stockholders for approval. Provisions in our organizational documents could prevent or frustrate attempts by stockholders to replace our current management. Our certificate of incorporation and bylaws contain provisions that could make it more difficult for a third party to acquire us without consent of our Board of Directors. Our certificate of incorporation provides for a staggered board and removal of directors only for cause. Accordingly, stockholders may elect only a minority of our Board at any annual meeting, which may have the effect of delaying or preventing changes in management. In addition, under our certificate of incorporation, our Board of Directors may issue additional shares of preferred stock and determine the terms of those shares of stock without any further action by our stockholders. Our issuance of additional preferred stock could make it more difficult for a third party to acquire a majority of our Table of Contents outstanding voting stock and thereby effect a change in the composition of our Board of Directors. Our certificate of incorporation also provides that our stockholders may not take action by written consent. Our bylaws require advance notice of stockholder proposals and director nominations and permit only our President or a majority of the Board of Directors to call a special stockholder meeting. These provisions may have the effect of preventing or hindering attempts by our stockholders to replace our current management. In addition, Delaware law prohibits a corporation from engaging in a business combination with any holder of 15% or more of its capital stock until the holder has held the stock for three years unless, among other possibilities, the Board of Directors approves the transaction. Our Board of Directors may use this provision to prevent changes in our management. Also, under applicable Delaware law, our Board of Directors may adopt additional anti-takeover measures in the future. Our stock has generally had low trading volume, and its public trading price has been volatile. Between our initial public offering on February 4, 2000 and June 30, 2009, and for the six months ended June 30, 2009, the closing price of our common stock has fluctuated between $0.30 and $52.63 per share and $0.30 and $2.67 per share, respectively. The average daily trading volume for the six months ended June 30, 2009 was approximately 1,751,000 shares, which is a significant increase from our average trading volume for the three months ended March 31, 2009 of 111,000 shares. The market may experience significant price and volume fluctuations that are often unrelated to the operating performance of individual companies. In addition to general market volatility, many factors may have a significant adverse effect on the market price of our stock, including: continuing operating losses, which we expect over the next several years as we continue our development activities; announcements of decisions made by public officials; results of our preclinical studies and clinical trials; announcements of technological innovations, new commercial products, failures of products, or progress toward commercialization by our competitors or peers; developments concerning proprietary rights, including patent and litigation matters; publicity regarding actual or potential results with respect to product candidates under development by us or by our competitors; regulatory developments; and quarterly fluctuations in our financial results. The sale of a significant number of shares could cause the market price of our stock to decline. The sale by us or the resale by stockholders of a significant number of shares of our common stock could cause the market price of our common stock to decline. As of June 30, 2009, we had 78,189,087 shares of common stock outstanding. All of these shares are eligible for sale on the NASDAQ, although certain of the shares are subject to sales volume and other limitations. We have filed registration statements to permit the sale of 25,436,831 shares of common stock under our equity incentive plan and certain equity plans that we assumed in the acquisitions of Aquila Biopharmaceuticals, Inc. and Aronex Pharmaceuticals, Inc. We have also filed registration statements to permit the sale of 1,000,000 shares of common stock under our employee stock purchase plan, to permit the sale of 450,000 shares of common stock under our Directors Deferred Compensation Plan, to permit the sale of 17,417,434 shares of common stock pursuant to the private placement agreement dated January 9, 2008 and to permit the sale of 14,000,000 shares of common stock pursuant to the private placement agreement dated April 8, 2008. As of June 30, 2009, an aggregate of 39,552,670 shares remain available for sale under these registration statements. The market price of our common stock may decrease based on the expectation of such sales. As of June 30, 2009, options to purchase 6,835,131 shares of our common stock with a weighted average exercise price per share of $4.57 were outstanding. Many of these options are subject to vesting that generally occurs over a period of up to four years following the date of grant. As of June 30, 2009, we have 1,872,919 nonvested shares outstanding. Because we are a relatively small public company we believe we have been disproportionately negatively impacted by the Sarbanes-Oxley Act of 2002 and related regulations which have increased our costs in the past and have required additional management resources. The Sarbanes-Oxley Act of 2002 and rules adopted by the SEC and the NASDAQ have historically resulted in significant costs to us. In addition, our efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and related regulations regarding the required assessment of our internal control over financial reporting, and our independent registered public accounting firm s audit of internal control over financial reporting, have required commitments of significant management time. We expect these commitments to continue. Additionally, these laws and regulations could make it more difficult for us to attract and retain qualified members for our Board of Directors, particularly independent directors, or qualified executive officers. Our internal control over financial reporting, as defined in Rules 13a-15 of the Securities Exchange Act of 1934 (the Securities Exchange Act ), is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the Table of Contents preparation of our consolidated financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect all deficiencies or weaknesses in our financial reporting. While our management has concluded that there were no material weaknesses in our internal control over financial reporting as of December 31, 2008, our procedures are subject to the risk that our controls may become inadequate because of changes in conditions or as a result of a deterioration in compliance with such procedures. No assurance is given that our procedures and processes for detecting weaknesses in our internal control over financial reporting will be effective. Table of Contents

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+RISK FACTORS Investors should carefully consider the risks and uncertainties and all other information contained or incorporated by reference in this prospectus, including the risks and uncertainties discussed under Risk Factors in our Annual Report on Form 10-K for the year ended September 30, 2009. All of these Risk Factors are incorporated by reference herein in their entirety. These risks and uncertainties are not the only ones facing us. Additional risks of which we are not presently aware or that we currently believe are immaterial may also harm our business and results of operations. The trading price of our common stock could decline due to the occurrence of any of these risks, and investors could lose all or part of their investment. In assessing these risks, investors should also refer to the other information contained or incorporated by reference in our other filings with the Securities and Exchange Commission. Table of Contents The information in this prospectus is not complete and may be changed. The security holders identified in this prospectus may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. PROSPECTUS (Subject to Completion) dated December 28, 2009 ARROWHEAD RESEARCH CORPORATION 19,363,502 shares of Common Stock This prospectus covers the sale of an aggregate of 19,363,502 shares of our Common Stock, $0.001 par value per share (the Common Stock ), by the selling security holders identified in this prospectus (collectively with any holder s transferee, pledgee, donee or successor, the Selling Stockholders ). The Common Stock covered by this prospectus consists of (i) 5,083,430 shares of Common Stock issued in a private placement that closed on December 11, 2009, (ii) 5,083,430 shares of common stock issuable upon exercise of warrants (the December Warrants ) issued in the same private placement that closed on December 11, 2009 (the December Private Placement ), and (iii) 9,196,642 shares issuable upon the exercise of warrants (the August Warrants, and together with the December Warrants, the Warrants ) issued in a private placement with a final closing in August 2009 (the August Private Placement ). The shares identified in clauses (i), (ii) and (iii) are referred to collectively as the Shares. The Company will not receive any proceeds from the sale by the Selling Stockholders of the Shares. However, the Company may indirectly receive proceeds to the extent that any Selling Stockholders exercise Warrants to purchase our Common Stock and then resell those Shares under this prospectus. We are paying the cost of registering the Shares covered by this prospectus as well as various related expenses. The Selling Stockholders are responsible for all selling commissions, transfer taxes and other costs related to the offer and sale of their Shares. If required, the number of Shares to be sold, the public offering price of those Shares, the names of any broker-dealers and any applicable commission or discount will be included in a supplement to this prospectus, called a prospectus supplement. The Company s Common Stock is traded on the NASDAQ Capital Market under the symbol ARWR . On December 24, 2009, the closing sale price of our Common Stock on the NASDAQ Capital Market was $0.53 per share. Our principal executive offices are located at 201 South Lake Avenue, Suite 703, Pasadena, California 91101, and our telephone number is (626) 304-3400. Investing in our securities involves risks. You should carefully consider the risk factors beginning on page 1 of this prospectus before you make an investment in our securities. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The date of this prospectus is Table of Contents

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+RISK FACTORS An investment in the notes involves risk. Before you decide to purchase the notes, you should carefully consider these risk factors together with all of the other information included in this prospectus, including the information contained in the section entitled Management s Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and the notes thereto. If any of the following risks actually occurs, our business, financial condition, operating results and prospects could be adversely affected, which in turn could adversely affect the value of the notes. Risks Related to Our Industry and Business Our utility operations are heavily regulated. Decisions by state PUCs and other regulatory agencies can significantly affect our business and results of operations. Our Regulated Businesses provide water and wastewater services to our customers through subsidiaries economically regulated by state PUCs. Economic regulation affects the rates we charge our customers and has a significant effect on our business and results of operations. Generally, the state PUCs authorize us to charge rates that they determine are sufficient to recover our prudently incurred operating expenses, to enable us to finance the addition of new, or the replacement of existing, water and wastewater infrastructure and to allow us the opportunity to earn what they determine to be an appropriate rate of return on our invested capital and a return of our invested capital. Our ability to meet our financial objectives depends upon the rates authorized by the various state PUCs. We periodically file rate increase applications with state PUCs. The ensuing administrative process may be lengthy and costly. We can provide no assurances that our rate increase requests will be granted. Even if approved, there is no guarantee that approval will be given in a timely manner or at a sufficient level to cover our expenses, the recovery of our investment and/or provide us an opportunity to earn an appropriate rate of return on our investment and a return of our investment. If the authorized rates are insufficient to cover operating expenses, to allow for the recovery of our investment and to provide an appropriate return on invested capital, or if the rate increase decisions are delayed, our financial condition, results of operations, cash flow and liquidity may be adversely affected. Even if rates are sufficient, we face the risk that we will not achieve the rates of return on our invested capital and a return of our invested capital that are permitted by the state PUC. Our operations and the quality of water we supply are subject to extensive environmental laws and regulations. Our operating costs have increased, and are expected to continue to increase, as a result of complying with environmental laws and regulations. We also could incur substantial costs as a result of violations of or liabilities under such laws and regulations. Our water and wastewater operations are subject to extensive United States Federal, state and local and, in the case of our Canadian operations, Canadian, laws and regulations, that govern the protection of the environment, health and safety, the quality of the water we deliver to our customers, water allocation rights, and the manner in which we collect, treat, discharge and dispose of wastewater. These requirements include the United States Clean Water Act of 1972, which we refer to as the Clean Water Act, and the United States Safe Drinking Water Act of 1974, which we refer to as the Safe Drinking Water Act, and similar state and Canadian laws and regulations. We are also required to obtain various environmental permits from regulatory agencies for our operations. State PUCs also set conditions and standards for the water and wastewater services we deliver. If we deliver water or wastewater services to our customers that do not comply with regulatory standards, or otherwise violate environmental laws, regulations or permits, or other health and safety and water quality regulations, we could incur substantial fines, penalties or other sanctions or costs or damage to our reputation. In the most serious cases, regulators could force us to discontinue operations and sell our operating assets to another utility or municipality. Given the nature of our business which, in part, involves supplying water for human consumption, any potential non-compliance with, or violation of, environmental laws or regulations would likely pose a more significant risk to us than to an issuer not similarly involved in the water and wastewater industry. Table of Contents We incur substantial operating and capital costs on an ongoing basis to comply with environmental laws and regulations and other health and safety and water quality regulations. These laws and regulations, and their enforcement, have tended to become more stringent over time, and new or stricter requirements could increase our costs. Although we may seek to recover ongoing compliance costs in our rates, there can be no guarantee that the various state PUCs or similar regulatory bodies that govern our Regulated Businesses would approve rate increases to recover such costs or that such costs will not adversely and materially affect our financial condition, results of operations, cash flow and liquidity. We may also incur liabilities under environmental laws and regulations requiring us to investigate and clean up environmental contamination at our properties or at off-site locations where we have disposed of waste or caused adverse environmental impacts. The discovery of previously unknown conditions, or the imposition of cleanup obligations in the future, could result in significant costs, and could adversely affect our financial condition, results of operations, cash flow and liquidity. Such remediation losses may not be covered by our insurance policies and may make it difficult for us to secure insurance in the future at acceptable rates. Changes in laws and regulations over which we have no control can significantly affect our business and results of operations. Any governmental entity that regulates our operations may enact new legislation or adopt new regulations or policies at any time, and new judicial decisions may change the interpretation of existing legislation or regulations at any time. The individuals who serve as regulators are elected or are political appointees. Therefore, elections which result in a change of political administration or new appointments may also result in changes in the individuals who serve as regulators and the policies of the regulatory agencies that they serve. New laws or regulations, new interpretations of existing laws or regulations, or changes in agency policy, including as a response to shifts in public opinion, or conditions imposed during the regulatory hearing process may affect our business in a number of ways, including the following: making it more difficult for us to raise our rates and, as a consequence, to recover our costs or earn our expected rates of return; changing the determination of the costs, or the amount of costs, that would be considered recoverable in rate cases; changing water quality or delivery service standards or wastewater collection, treatment, discharge and disposal standards with which we must comply; restricting our ability to terminate our services to customers who owe us money for services previously provided; requiring us to provide water services at reduced rates to certain customers; restricting our ability to sell assets or issue securities; changing regulatory benefits that we expected to receive when we began offering services in a particular area; changing or placing additional limitations on change in control requirements relating to any concentration of ownership of our common stock; making it easier for governmental entities to convert our assets to public ownership via eminent domain; restricting or prohibiting our extraction of water from rivers, streams, reservoirs or aquifers; and revoking or altering the terms of the certificates of public convenience and necessity (or similar authorizations) issued to us by state PUCs. Any of these changes or any other changes in laws, regulations, judicial decisions or agency policies applicable to us may have an adverse effect on our business, financial condition, results of operations, cash flow and liquidity. Table of Contents Weather conditions, natural hazards, availability of water supplies and competing uses may interfere with our sources of water, demand for water services and our ability to supply water to customers. Our ability to meet the existing and future water demands of our customers depends on an adequate supply of water. As a general rule, sources of public water supply, including rivers, lakes, streams and groundwater aquifers are held in the public trust and are not owned by private interests. As such, we typically do not own the water that we use in our operations, and the availability of our water supply is established through allocation rights and passing-flow requirements set by governmental entities. Passing-flow requirements set minimum volumes of water that must pass through specified water sources, such as rivers and streams, in order to maintain environmental habitats and meet water allocation rights of downstream users. Allocation rights are imposed to ensure sustainability of major water sources and passing flow requirements are most often imposed on source waters from smaller rivers, lakes and streams. These requirements can change from time to time and adversely impact our water supply. Drought, overuse of sources of water, the protection of threatened species or habitats or other factors may limit the availability of ground and surface water. Governmental restrictions on water use may also result in decreased use of water services, even if our water supplies are sufficient to serve our customers, which may adversely affect our financial condition and results of operations. Seasonal drought conditions that would impact our water services are possible across all of our service areas, and drought conditions currently exist in several areas of the United States. However, these conditions are more prevalent in the Northeast and West where supply capacity is limited and per capita water demand is high. If a regional drought were to occur affecting our service areas and adjacent systems, governmental restrictions may be imposed on all systems within a region independent of the supply adequacy of any individual system. There have been no mandatory water use restriction orders to date in 2008, although voluntary conservation efforts or water use restrictions were implemented during certain periods in parts of New Jersey, New Mexico, New York and California. Following drought conditions, water demand may not return to pre-drought levels even after restrictions are lifted. Cool and wet weather may also reduce demand for water, thereby adversely affecting our financial condition, results of operations, cash flow and liquidity. Service interruptions due to severe weather events are possible across all our service areas. These include winter storms and freezing conditions in our colder climate service areas, high wind conditions in our service areas known to experience tornados, earthquakes in our service areas known to experience seismic activity, high water conditions for our facilities located in or near designated flood plains, hurricanes in our coastal service areas and severe electrical storms which are possible across all of our service areas. These weather events may affect the condition or operability of our facilities, limiting or preventing us from delivering water or wastewater services to our customers, or requiring us to make substantial capital expenditures to repair any damage. Any interruption in our ability to supply water or to collect, treat and properly dispose of wastewater, or any costs associated with restoring service, could adversely affect our financial condition and results of operations. Furthermore, losses from business interruptions or damage to our facilities might not be covered by our insurance policies and such losses may make it difficult for us to secure insurance in the future at acceptable rates. Declining residential per customer water usage may reduce our long-term revenues, financial condition and results of operations. Increased water conservation, including through the use of more efficient household fixtures and appliances among residential consumers, combined with declining household sizes in the United States, has contributed to a trend of declining residential per customer water usage. Our Regulated Businesses are heavily dependent upon revenue generated from rates we charge to our residential customers for the volume of water they use. The rate we charge for our water is regulated by state PUCs, and we may not unilaterally adjust our rates to reflect demand. Declining usage will have a negative impact on our long-term operating revenues if we are unable to secure rate increases or to grow our residential customer base to the extent necessary to offset the residential usage decline. Table of Contents Risks associated with the collection, treatment and disposal of wastewater may impose significant costs. The wastewater collection, treatment and disposal operations of our subsidiaries are subject to substantial regulation and involve significant environmental risks. If collection or sewage systems fail, overflow or do not operate properly, untreated wastewater or other contaminants could spill onto nearby properties or into nearby streams and rivers, causing damage to persons or property, injury to aquatic life and economic damages, which may not be recoverable in rates. This risk is most acute during periods of substantial rainfall or flooding, which are the main causes of sewer overflow and system failure. Liabilities resulting from such damage could adversely and materially affect our business, results of operations and financial condition. Moreover, in the event that we are deemed liable for any damage caused by overflow, our losses might not be covered by insurance policies, and such losses may make it difficult for us to secure insurance in the future at acceptable rates. Our Regulated Businesses require significant capital expenditures to maintain infrastructure and expand our rate base and may suffer if we fail to secure appropriate funding to make investments, or if we suffer delays in completing major capital expenditure projects. The water and wastewater utility business is capital intensive. In addition to our acquisition strategy, we invest significant amounts of capital to add, replace and maintain property, plant and equipment. In 2007, we invested $758.6 million in net Company-funded capital improvements. We invested approximately $1.0 billion in net capital improvements in 2008. We expect the level of capital expenditures necessary to maintain the integrity of our systems to increase in the future. We fund these projects from cash generated from operations, borrowings under our revolving credit facility and commercial paper programs and the issuance of long-term debt and equity securities. We can provide no assurances that we will be able to access the debt and equity capital markets on favorable terms or at all. RWE has certain registration rights with respect to future issuances of our equity securities and intends to fully divest its remaining ownership of American Water as soon as reasonably practicable, subject to market conditions. The registration rights agreement entered into with RWE imposes certain restrictions on our ability to issue equity securities in amounts beyond specified thresholds without RWE s consent. Sales of our common stock by RWE as well as the restrictions in the registration rights agreement, may make it more difficult or costly for us to raise additional equity in the future. Furthermore, if we are unable to raise sufficient equity, we can provide no assurances that we will be able to access the debt capital markets on favorable terms or at all. In addition, we believe that our dividend policy, which, subject to applicable law and the discretion of our board of directors, is to pay cash dividends of approximately $0.20 per share per quarter, could limit, but not preclude, our ability to pursue growth. In particular, this limitation could be significant, for example, with respect to large acquisitions and growth opportunities that require cash investments in amounts greater than our operating subsidiaries available cash or external financing resources. In order to fund construction expenditures, acquisitions (including tuck-in acquisitions) and principal and interest payments on our indebtedness, and pay dividends at the level currently anticipated under our dividend policy, we expect that we will need additional financing. However, we intend to retain sufficient cash from operating activities after the distribution of dividends to fund a portion of our capital expenditures. For further discussion of our acquisition strategy, see Business Our Regulated Businesses Acquisitions. If we are unable to obtain sufficient capital, we may fail to maintain our existing property, plant and equipment, realize our capital investment strategies, meet our growth targets and successfully expand the rate base upon which we are able to earn future returns on our investment and a return of our investment. Even if we have adequate resources to make required capital expenditures, we face the additional risk that we will not complete our major capital expenditures on time, as a result of construction delays or other obstacles. Each of these outcomes could adversely affect our financial condition and results of operations. We also face the risk that after we make substantial capital expenditures, the rate increases granted to us by state PUCs may not be sufficient to recover our prudently incurred operating expenses and to allow us the opportunity to earn an appropriate rate of return on our invested capital and a return of our invested capital. Table of Contents Market disruptions could affect our ability to meet our liquidity needs. We rely on our revolving credit facility and the capital markets to satisfy our liquidity needs. Disruptions in the credit markets may discourage lenders from meeting their existing lending commitments, extending the terms of such commitments or agreeing to new commitments. Market disruptions may also limit our ability to issue debt securities in the capital markets. On September 15, 2008, we sought to issue commercial paper but were unable to consummate the issuance due to adverse market conditions. In order to meet our short-term liquidity needs we are borrowing under our existing $840 million revolving credit facility, which was scheduled to expire on September 15, 2012. On September 15, 2008, a majority of our lenders agreed to extend $685.0 million of commitments under this revolving credit facility to September 15, 2013. AWCC had $437.0 million of outstanding borrowings and $43.7 million of outstanding letters of credit under this credit facility as of January 15, 2009. AWCC had $81.0 million of outstanding overnight commercial paper as of January 15, 2009. We can provide no assurances that our lenders will meet their existing commitments or that we will be able to access the commercial paper or loan markets in the future on terms acceptable to us or at all. The failure of, or the requirement to repair, upgrade or dismantle, any of our dams may adversely affect our financial condition and results of operations. We own a total of 99 dams. A failure of any of those dams could result in injuries and property damage downstream for which we may be liable. The failure of a dam would also adversely affect our ability to supply water in sufficient quantities to our customers and could adversely affect our financial condition and results of operations. Any losses or liabilities incurred due to a failure of one of our dams might not be covered by insurance policies or be recoverable in rates, and such losses may make it difficult for us to secure insurance in the future at acceptable rates. We also are required from time to time to repair or upgrade the dams that we own. The cost of such repairs can be and has been material. We might not be able to recover such costs through rates. The inability to recover these higher costs or regulatory lag in the recovery of such costs can affect our financial condition, results of operations, cash flow and liquidity. The federal and state agencies that regulate our operations may adopt rules and regulations requiring us to dismantle our dams. Federal and state agencies are currently considering rules and regulations that could require us to strengthen or dismantle one of our dams on the Carmel River in California due to safety concerns related to seismic activity. Any requirement to strengthen or dismantle this dam could result in substantial costs that may adversely affect our financial condition and results of operations. We are currently engaged in negotiations with federal and state agencies and local stakeholders on a plan to maintain our existing Carmel River dams or to share the costs of dismantling one of them with those federal and state agencies and local stakeholders. These negotiations could be delayed or abandoned. Any failure of our network of water and wastewater pipes and water reservoirs could result in losses and damages that may affect our financial condition and reputation. Our operating subsidiaries distribute water and wastewater through an extensive network of pipes and store water in reservoirs located across the United States. A failure of major pipes or reservoirs could result in injuries and property damage for which we may be liable. The failure of major pipes and reservoirs may also result in the need to shut down some facilities or parts of our network in order to conduct repairs. Such failures and shutdowns may limit our ability to supply water in sufficient quantities to our customers and to meet the water and wastewater delivery requirements prescribed by governmental regulators, including state PUCs with jurisdiction over our operations, and adversely affect our financial condition, results of operations, cash flow, liquidity and reputation. Any business interruption or other losses might not be covered by insurance policies or be recoverable in rates, and such losses may make it difficult for us to secure insurance in the future at acceptable rates. Table of Contents Contamination of our sources of water could result in service interruptions and human exposure to hazardous substances and subject our subsidiaries to civil or criminal enforcement actions, private litigation and cleanup obligations. Our water supplies are subject to contamination, including contamination from naturally-occurring compounds, chemicals in groundwater systems, pollution resulting from man-made sources, such as perchlorate and methyl tertiary butyl ether (MTBE), and possible terrorist attacks. In the event that our water supply is contaminated, we may have to interrupt the use of that water supply until we are able to substitute the supply of water from another water source, including, in some cases, through the purchase of water from a third-party supplier. In addition, we may incur significant costs in order to treat the contaminated source through expansion of our current treatment facilities, or development of new treatment methods. If we are unable to substitute water supply in a cost-effective manner, our financial condition, results of operations, cash flow, liquidity and reputation may be adversely affected. We might not be able to recover costs associated with treating or decontaminating water supplies through rates, or such recovery may not occur in a timely manner. Moreover, we could be held liable for environmental damage as well as damages arising from toxic tort or other lawsuits or criminal enforcement actions or other consequences arising out of human exposure to hazardous substances in our drinking water supplies. Our liquidity and earnings could be adversely affected by increases in our production costs, including the cost of chemicals, electricity, fuel or other significant materials used in the water and wastewater treatment process. We incur significant production costs in connection with the delivery of our water and wastewater services. Our production costs are driven by inputs such as chemicals used to treat water and wastewater as well as electricity and fuel, which are used to operate pumps and other equipment used in water treatment and delivery and wastewater collection, treatment and disposal. We also incur production costs for waste disposal. For 2007, production costs accounted for 12.6% of our total operating costs. These costs can and do increase unexpectedly and in substantial amounts, as occurred in California during 2001 and Illinois during 2007, when the cost of electricity rose substantially. Our Regulated Businesses might not be able to recover increases in the costs of chemicals, electricity, fuel, other significant inputs or waste disposal through rates, or such recovery may not occur in a timely manner. Our Non-Regulated Businesses may not be able to recover these costs in contract prices or other terms. The inability to recover these higher costs can affect our financial condition, results of operations, cash flow and liquidity. Our reliance on third-party suppliers poses significant risks to our business and prospects. We contract with third parties for goods and services that are essential to our operations, such as maintenance services, pipes, chemicals, electricity, water, gasoline, diesel and other materials. We are subject to substantial risks because of our reliance on these suppliers. For example: our suppliers may not provide raw materials that meet our specifications in sufficient quantities; our suppliers may provide us with water that does not meet applicable quality standards or is contaminated; our suppliers may face production delays due to natural disasters or strikes, lock-outs or other such actions; one or more suppliers could make strategic changes in the lines of products and services they offer; and some of our suppliers are small companies which are more likely to experience financial and operational difficulties than larger, well-established companies, because of their limited financial and other resources. Table of Contents As a result of any of these factors, we may be required to find alternative suppliers for the raw materials and services on which we rely. Accordingly, we may experience delays in obtaining appropriate raw materials and services on a timely basis and in sufficient quantities from such alternative suppliers at a reasonable price, which could interrupt services to our customers and adversely affect our revenues, financial condition, results of operations, cash flow and liquidity. Risks associated with potential acquisitions or investments may adversely affect us. We will continue to seek to acquire or invest in additional regulated water or wastewater systems, including by acquiring systems in markets in the United States where we do not currently operate our Regulated Businesses, and through tuck-ins. We will also continue to seek to enter into public/private partnerships, including O&M, military and design, build and operate, which we refer to as DBO, contracts and services that complement our businesses. These transactions may result in: incurrence of debt and contingent liabilities; failure to have or to maintain effective internal control over financial reporting; fluctuations in quarterly results; exposure to unknown risk and liabilities, such as environmental liabilities; and other acquisition-related expenses. We may also experience difficulty in obtaining required regulatory approvals for acquisitions, and any regulatory approvals we obtain may require us to agree to costly and restrictive conditions imposed by regulators. Sales of our common stock by RWE as well as the restrictions in the registration rights agreement between us and RWE, may make it more difficult or costly for us to raise additional equity to fund an acquisition or to issue shares as consideration in connection with an acquisition. We may not identify all significant risks when conducting due diligence for a transaction, and we could be exposed to potential liabilities for which we will not be indemnified. There may be difficulties integrating new businesses, including bringing newly acquired businesses up to the necessary level of regulatory compliance, retaining and integrating key personnel, achieving strategic objectives and integrating acquired assets and technological systems. The demands of identifying and transitioning newly acquired businesses or pursuing investment opportunities may also divert management s attention from other business concerns and otherwise disrupt our business. Any of these risks may adversely affect our financial condition, results of operations and cash flows. We have recorded a significant amount of goodwill, and we may never realize the full value of our intangible assets, causing us to record impairments that may negatively affect our results of operations or require us to effect additional dilutive equity issuances. Our total assets include substantial goodwill. At September 30, 2008, our goodwill totaled $1,704.3 million. The goodwill is primarily associated with the acquisition of American Water by an affiliate of RWE in 2003 and the acquisition of E Town Corporation in 2001. Goodwill represents the excess of the purchase price the purchaser paid over the fair value of the net tangible and intangible assets acquired. Goodwill is recorded at fair value on the date of an acquisition and, in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, which we refer to as SFAS No. 142, is reviewed annually or more frequently if changes in circumstances indicate the carrying value may not be recoverable. Annual impairment reviews are performed at November 30 of each year and interim reviews are performed when management determines that a triggering event has occurred. We have been required to reflect, as required by SFAS No. 142 and other applicable accounting rules, a non-cash charge to operating results for goodwill impairment in the amounts of $396.3 million, $227.8 million, and $509.3 million for the years ended December 31, 2005, 2006 and 2007, respectively. These amounts include impairments relating to discontinued operations. Also, for the three months ended March 31, 2008 we recorded a goodwill impairment in the amount of $750.0 million. Table of Contents There can be no assurances that the Company will not be required to recognize an impairment of goodwill in the future due to market conditions or other factors related to the Company s performance. These market events could include a decline over a period of time of the Company s stock price, a decline over a period of time in valuation multiples of comparable water utilities, the lack of an increase in the Company s market price consistent with its peer companies, or decreases in control premiums and the overhang effect. A decline in the forecasted results in our business plan, such as changes in rate case results or capital investment budgets or changes in our interest rates, could also result in an impairment charge. Recognition of impairments of a significant portion of goodwill would negatively affect the Company s reported results of operations and total capitalization, the effect of which could be material and could make it more difficult to secure financing on attractive terms, maintain compliance with debt covenants and meet expectations of our regulators. As a result, we may be required to issue and sell additional shares of common stock at market prices, which could be dilutive to existing holders of our common stock. For further discussion, see Management s Discussion and Analysis of Financial Condition and Results of Operations Factors Affecting our Results of Operations Goodwill Impairment. While our annual goodwill impairment test is conducted at November 30, we have processes to monitor for interim triggering events. As of March 31, 2008, in light of the initial public offering price and trading levels in our common stock subsequent to the date of the initial public offering, the Company performed an interim impairment test and, on May 9, 2008, management concluded that the carrying value of the Company s goodwill was impaired. The Company believed that the initial public offering price was indicative of the value of the Company at March 31, 2008, and accordingly, based on those factors recorded an impairment charge to the goodwill of its Regulated reporting unit in the amount of $750.0 million as of March 31, 2008. The impairment charge was primarily attributed to the market price of the Company s common stock (both the initial public offering price and the price during subsequent trading) being less than the estimate of the initial public offering price used during the 2007 annual test. Also contributing to the impairment was a decline in the fair value of the Company s debt (due to increased market interest rates). As a result of the impairment charge, RWE Aqua Holdings GmbH (a wholly-owned subsidiary of RWE) transferred $245.0 million to the Company on May 13, 2008. This cash was used to reduce short-term debt. RWE is not obligated to make any additional capital contributions. During the third quarter of 2007, as a result of the Company s debt being placed on review for a possible downgrade and the proposed sale of a portion of the Company in the initial public offering, management determined at that time it was appropriate to update its valuation analysis before the next scheduled annual test. Based on this assessment, the Company performed an interim impairment test and recorded an impairment charge to goodwill related to its Regulated reporting unit in the amount of $243.3 million as of September 30, 2007. The decline was primarily due to a slightly lower long-term earnings forecast caused by updated customer demand and usage expectations and expectations for timing of capital expenditures and rate recovery. The Company completed its scheduled annual impairment test in the fourth quarter of 2007 and determined that an impairment had occurred based upon information regarding the Company s market value in connection with the initial public offering. Management determined that the indicative fair value of the Company based on estimates of the initial public offering price range was the best evidence of the Company s market value and incorporated this indicated market value into the Company s valuation methodology, which also considered other items, such as peer multiples, discounted cash flows and a control premium. Based on the results of the impairment test, an impairment of $266.0 million to the Company s carrying value was recognized as of December 31, 2007. Our Regulated Businesses compete with governmental entities, other regulated utilities, as well as strategic and financial buyers, for acquisition opportunities, which may hinder our ability to grow our business. We compete with governmental entities, other regulated utilities, as well as strategic and financial buyers, for acquisition opportunities, including tuck-ins. Our competitors may impede our growth by purchasing water utilities near our existing operations, thereby preventing us from acquiring them. Competing governmental Table of Contents entities, utilities and strategic and financial buyers have challenged, and may in the future challenge, our applications for new service territories. Our growth could be hindered if we are not able to compete effectively for new territories with other companies or strategic and financial buyers that have lower costs of operations or that can submit more attractive bids. The assets of our Regulated Businesses are subject to condemnation through eminent domain. Municipalities and other government subdivisions have historically been involved in the provision of water and wastewater services in the United States, and organized movements may arise from time to time in one or more of the service areas in which our Regulated Businesses operate to convert our assets to public ownership and operation through the governmental power of eminent domain. Should a municipality or other government subdivision seek to acquire our assets through eminent domain, we may resist the acquisition. Contesting an exercise of condemnation through eminent domain may result in costly legal proceedings and may divert the attention of the affected Regulated Business s management from the operation of its business. On September 5, 2008, under threat of condemnation, California American Water sold the assets of our Felton, California water system, which served approximately 1,330 customers, to the San Lorenzo Valley Water District, which we refer to as SLVWD. The most recent prior sale of our water and wastewater systems under threat of condemnation occurred in 2003. If a municipality or other government subdivision succeeds in acquiring the assets of one or more of our Regulated Businesses through eminent domain, there is a risk that we will not receive adequate compensation for the business, that we will not be able to keep the compensation, or that we will not be able to divest the business without incurring significant one-time charges. In order to consummate the proposed RWE Divestiture, we and RWE were required to obtain approvals from thirteen state PUCs. There can be no guarantee that some state PUC approvals already granted to us will not be appealed, withdrawn, modified or stayed. To consummate the proposed RWE Divestiture, we and RWE obtained regulatory approvals from state PUCs in 13 states. The state PUC approval in Illinois has been appealed, and there can be no guarantee that the state PUC approval in Illinois will not be overturned. Moreover, some of our existing state PUC approvals may be withdrawn or altered in the future by the state PUCs because they retain authority to withdraw or modify their prior decisions. There also can be no guarantee that, in conjunction with an appeal or otherwise, a stay or other form of injunctive relief will not be granted by a state PUC or reviewing court. In addition, two of the regulatory approvals that we and RWE obtained expire on April 22, 2010 and another approval expires on April 22, 2011. If RWE does not fully divest its remaining ownership of American Water by such dates, then we and RWE may be required to seek an extension of such approvals, as applicable, which process may result in delays, costs and the imposition of additional conditions on us or on RWE. In order to obtain the state PUC approvals to consummate the proposed RWE Divestiture we were required to accept certain conditions and restrictions that could increase our costs. Some of the regulatory approvals contain conditions and restrictions, including reporting obligations, obligations to maintain appropriate creditworthiness, restrictions on changes of control, prohibitions on the pass- through of our initial Sarbanes-Oxley Act compliance costs, prohibitions on the pass-through of certain costs of the Transactions, service quality and staffing level requirements and the maintenance of specific collective bargaining agreements and retirement and certain other post-employment benefit programs. These conditions and restrictions could increase our costs and adversely affect our business. Table of Contents Our Non-Regulated Businesses, through American Water (excluding our regulated subsidiaries), provide performance guarantees and other forms of financial security to our public-sector clients that could be claimed by our clients or potential clients if we do not meet certain obligations. Under the terms of some of our indebtedness and some of our agreements for the provision of services to water and wastewater facilities with municipalities, other governmental entities and other customers, American Water (excluding its regulated subsidiaries) provides guarantees of the performance of our Non-Regulated Businesses, including financial guarantees or deposits, to ensure performance of certain obligations. At September 30, 2008, we had remaining performance commitments as measured by remaining contract revenue totaling approximately $1,680.2 million, and this amount is likely to increase if our Non-Regulated Businesses grow. The presence of these commitments may adversely affect our financial condition and make it more difficult for us to secure financing on attractive terms. In addition, if the obligor on the instrument fails to perform certain obligations to the satisfaction of the party that holds the performance commitments that party may seek to enforce the performance commitments against us or proceed against the deposit. In that event, our financial condition, results of operations, cash flow and liquidity could be adversely affected. We operate a number of water and wastewater systems under O&M contracts and face the risk that the owners of those systems may fail to maintain those systems, which will negatively affect us as the operators of the systems. We operate a number of water and wastewater systems under O&M contracts. Pursuant to these contracts, we operate the system according to the standards set forth in the applicable contract, and it is generally the responsibility of the owner to undertake capital improvements. In some cases, we may not be able to convince the owner to make needed improvements in order to maintain compliance with applicable regulations. Although violations and fines incurred by water and wastewater systems may be the responsibility of the owner of the system under these contracts, those non-compliance events may reflect poorly on us as the operator of the system and damage our reputation, and in some cases, may result in liability to the same extent as if we were the owner. Our Non-Regulated Businesses are party to long-term contracts to operate and maintain water and wastewater systems under which we may incur costs in excess of payments received. Some of our Non-Regulated Businesses enter into long-term contracts pursuant to which they agree to operate and maintain a municipality s, Federal government s or other party s water or wastewater treatment and delivery facilities, which includes responsibility for certain major maintenance for some of those facilities, in exchange for an annual fee. Our Non-Regulated Businesses are generally subject to the risk that costs associated with operating and maintaining the facilities may exceed the fees received from the municipality or other contracting party. In addition, directly or through our non-regulated subsidiaries, we often guarantee our Non-Regulated Businesses obligations under those contracts. Losses under these contracts or guarantees may adversely affect our financial condition, results of operations, cash flow and liquidity. We rely on our IT systems to assist with the management of our business and customer and supplier relationships, and a disruption of these systems could adversely affect our business. Our IT systems are an integral part of our business, and a serious disruption of our IT systems could significantly limit our ability to manage and operate our business efficiently, which in turn could cause our business and competitive position to suffer and cause our results of operations to be reduced. We depend on our IT systems to bill customers, process orders, provide customer service, manage construction projects, manage our financial records, track assets, remotely monitor certain of our plants and facilities and manage human resources, inventory and accounts receivable collections. Our IT systems also allow us to purchase products from our suppliers and bill customers on a timely basis, maintain cost-effective operations and provide service to our customers. Our IT systems are vulnerable to damage or interruption from: power loss, computer systems failures and internet, telecommunications or data network failures; operator negligence or improper operation by, or supervision of, employees; Table of Contents physical and electronic loss of customer data or security breaches, misappropriation and similar events; computer viruses; intentional acts of vandalism and similar events; and hurricanes, fires, floods, earthquakes and other natural disasters. Such damages or interruptions may result in physical and electronic loss of customer or financial data, security breaches, misappropriation and similar events. In addition, the lack of redundancy for certain of our IT systems, including billing systems, could exacerbate the impact on the Company of any of the foregoing events. In addition, we may not be successful in developing or acquiring technology that is competitive and responsive to the needs of our business and we might lack sufficient resources to make the necessary investments in technology to allow us to continue to operate at our current level of efficiency. Our indebtedness could affect our business adversely and limit our ability to plan for or respond to changes in our business, and we may be unable to generate sufficient cash flow to satisfy our liquidity needs. As of September 30, 2008, after giving effect to this offering and the issuance of the existing senior monthly notes, our pro forma indebtedness (including preferred stock with mandatory redemption requirements) was $5,122.6 million, and our working capital, defined as current assets less current liabilities, was in a deficit position. Our indebtedness could have important consequences, including: limiting our ability to obtain additional financing to fund future working capital or capital expenditures; exposing us to interest rate risk with respect to the portion of our indebtedness that bears interest at a variable rate; limiting our ability to pay dividends on our common stock or make payments in connection with our other obligations; likely requiring that a portion of our cash flow from operations be dedicated to the payment of the principal of and interest on our debt, thereby reducing funds available for future operations, acquisitions, dividends on our common stock or capital expenditures; limiting our ability to take advantage of significant business opportunities, such as acquisition opportunities, and to react to changes in market or industry conditions; and placing us at a competitive disadvantage compared to those of our competitors that have less debt. In order to meet our capital expenditure needs, we may be required to make additional borrowings under our credit facilities or be required to issue new debt securities in the capital markets. We can provide no assurances that we will be able to access the debt capital markets or do so on favorable terms. If new debt is added to our current debt levels, the related risks we now face could intensify, limiting our ability to refinance existing debt on favorable terms. We will depend primarily on operations to fund our expenses and to pay the principal and interest on our outstanding debt. Our ability to meet our expenses thus depends on our future performance, which will be affected by financial, business, economic, competitive, legislative, regulatory and other factors beyond our control. If we do not have enough money to pay the principal and interest on our outstanding debt, we may be required to refinance all or part of our existing debt, sell assets, borrow additional funds or sell additional equity. If our business does not generate sufficient cash flow from operations or if we are unable to incur indebtedness sufficient to enable us to fund our liquidity needs, we may be unable to plan for or respond to changes in our business that would prevent us from maintaining or increasing our business and cause our operating results and prospects to be affected adversely. Table of Contents Our failure to comply with restrictive covenants under our credit facilities could trigger prepayment obligations. Our failure to comply with the restrictive covenants under our credit facilities could result in an event of default, which, if not cured or waived, could result in us being required to repay or refinance (on less favorable terms) these borrowings before their due date. If we are forced to repay or refinance (on less favorable terms) these borrowings, our results of operations and financial condition could be adversely affected by increased costs and rates. In 2007, we were not in compliance with reporting covenants contained in some of the debt agreements of our subsidiaries. Such defaults under the reporting covenants were caused by our delay in producing our quarterly and audited annual consolidated financial statements. We have obtained all necessary waivers under the agreements. We can provide no assurance that we will comply in the future with all our reporting covenants and will not face an event of default under our debt agreements, or that such default will be cured or waived. Work stoppages and other labor relations matters could adversely affect our results of operations. Currently, approximately 3,700 of our employees, or approximately 51% of our total workforce, are unionized and represented by 20 different unions. Approximately one-fourth of our 76 union collective bargaining agreements expire annually, with 18 agreements covering 982 employees scheduled to expire before the end of 2009. We might not be able to renegotiate labor contracts on terms that are favorable to us and negotiations or dispute resolutions undertaken in connection with our labor contracts could be delayed or become subject to the risk of labor actions or work stoppages. Labor actions, work stoppages or the threat of work stoppages and our failure to obtain favorable labor contract terms during renegotiations may all adversely affect our financial condition, results of operations, cash flow and liquidity. We currently have material weaknesses in internal control over financial reporting. If we fail to remedy our material weaknesses or otherwise maintain effective internal control over financial reporting, we may not be able to report our financial results accurately or on a timely basis. Any inability to report and file our financial results in an accurate and timely manner could harm our business and adversely impact the trading price of our common stock. As a public company, we are required to comply with the Sarbanes-Oxley Act and other rules and regulations that govern public companies. In particular, we will be required to certify our compliance with Section 404 of the Sarbanes-Oxley Act for the year ended December 31, 2009, which will require us to perform system and process evaluation and testing of our internal control over financial reporting to allow management and our registered public accounting firm to report on the effectiveness of our internal control over financial reporting. Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles. However, from 2003 until the completion of our initial public offering in April 2008, we were an indirect wholly-owned subsidiary of RWE, a stock corporation incorporated in the Federal Republic of Germany, and were not required to maintain a system of effective internal controls in compliance with the requirements of the SEC and the Sarbanes-Oxley Act, nor to prepare our own consolidated financial statements. As a public reporting company, we are required, among other things, to maintain a system of effective internal control over financial reporting suitable to prepare our publicly reported financial statements in a timely and accurate manner, and also to evaluate and report on such system of internal control. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company s annual or interim financial statements will not be prevented or detected on a timely basis. In connection with the preparation of our consolidated financial statements as of December 31, 2006, we and our independent registered public accountants have identified the following material weaknesses in our internal control over financial reporting: inadequate internal staffing and skills; Table of Contents inadequate controls over financial reporting processes; inadequate controls over month-end closing processes, including account reconciliations; inadequate controls over maintenance of contracts and agreements; inadequate controls over segregation of duties and restriction of access to key accounting applications; and inadequate controls over tax accounting and accruals. We have initiated a remediation plan with respect to our material weaknesses, but there can be no assurances that our remediation plan will be effective. For further discussion, see Management s Discussion and Analysis of Financial Condition and Results of Operations Our Internal Control and Remediation Initiatives. Each of these weaknesses could result in a material misstatement of our annual or interim consolidated financial statements. Moreover, we cannot assure you that we have identified all, or that we will not in the future have additional, material weaknesses, any of which may subject us to additional regulatory scrutiny, and cause future delays in filing our financial statements and periodic reports with the SEC. Any such delays in the filing of our financial statements and periodic reports may result in a loss of public confidence in the reliability of our financial statements and sanctions imposed on us by the SEC. We believe that such misstatements or delays could negatively impact our liquidity, access to capital markets, financial condition and the market value of our common stock or cause a downgrade in the credit ratings of American Water or AWCC. These material weaknesses contributed to our inability to comply with reporting covenants in our debt agreements and those of our subsidiaries in 2005 and 2006, and could hinder our ability to comply with such covenants in the future if we are not successful in remediating such weaknesses. Risks Related to this Offering The notes are structurally subordinated to all the obligations of our subsidiaries other than the issuer. The issuer s ability to service its debt is dependent on the performance of our other subsidiaries. The notes have been issued by American Water Capital Corp., our finance subsidiary. American Water has signed a support agreement with the issuer. The notes are not guaranteed by any of our subsidiaries and are the obligations only of the issuer and American Water, by virtue of the support agreement. Accordingly, the notes are structurally subordinated to the liabilities, including trade payables, lease commitments and moneys borrowed, of American Water s subsidiaries other than the issuer. American Water has no material assets or operations other than equity interests in its subsidiaries, and the issuer has no material assets or operations except for its limited operations as a finance vehicle for our businesses. We expect that payments of interest and principal that the issuer makes on the notes (or that American Water makes pursuant to the support agreement) will be made only to the extent that our operating subsidiaries can distribute cash or other property to American Water and, through American Water, to the issuer. The notes do not restrict our ability to incur additional indebtedness, which could adversely affect our ability to pay our obligations under the notes. Although the terms of the notes restrict our ability and the ability of our subsidiaries to incur certain liens and to enter into certain sale and leaseback transactions, the incurrence of other indebtedness or other liabilities by any of our subsidiaries is not prohibited in connection with the notes and could adversely affect our ability to pay our obligations on the notes. As of September 30, 2008, total liabilities of our subsidiaries other than the issuer were $5,203.5 million. As of September 30, 2008, the indebtedness of our subsidiaries other than the issuer, excluding intercompany liabilities and obligations of a type not required to be reflected on a balance sheet in accordance with generally accepted accounting principles, that would effectively have been senior to the notes, was approximately $1,766.8 million. We anticipate that from time to time our subsidiaries will incur additional debt and other liabilities. Any debt incurred by our subsidiaries other than the issuer will be structurally senior to the notes. Table of Contents We have not agreed to any financial covenants in connection with the notes. Consequently, we are not required in connection with the notes to meet any financial tests, such as those that measure our working capital, interest coverage, fixed charge or net worth, in order to maintain compliance with the terms of the notes. Our ability to service our obligations under the notes depends on our ability to receive cash distributions from our operating subsidiaries. There can be no assurance that we will continue to receive such distributions or, if they are received, that they will be in amounts similar to past distributions. The issuer is our finance subsidiary and has no substantial assets. We have entered into a support agreement with the issuer pursuant to which we have agreed to pay to any debt investor or lenders of the issuer any principal or interest amounts owed by the issuer to such debt investor or lender that the issuer fails to pay on a timely basis. Because substantially all of our operations are conducted through our subsidiaries other than the issuer, the issuer will not be able to make interest and principal payments on the notes (and we will not be able to fulfill our obligations under the support agreement) unless we receive sufficient cash distributions from our operating subsidiaries and contribute such distributions to the issuer. The distributions received from our operating subsidiaries might not permit the issuer or us to make required payments of interest and principal under the notes or pursuant to the support agreement, as applicable, on a timely basis, or at all. If an active trading market does not develop for the notes you may not be able to resell them. Currently, there is no public market for the notes. If no active trading market develops, you may not be able to resell the notes at their fair market value or at all. The liquidity of any market for the notes will depend upon various factors, including: the number of holders of the notes; the interest of securities dealers in making a market for the notes; our financial performance or prospects; and the prospects for companies in our industry generally. Accordingly, we cannot assure you that a market or liquidity will develop for the notes. Our principal stockholder is in a position to affect our ongoing operations, corporate transactions and other matters, and its interests may conflict with or differ from your interests as a noteholder. RWE owns approximately 60% of our common stock. As a result, RWE is able to control the outcome on virtually all matters submitted to a vote of our stockholders, including the election of directors. So long as RWE continues to own a significant portion of the outstanding shares of our common stock, it will continue to be able to significantly influence the election of our directors, subject to compliance with applicable NYSE requirements, our decisions, policies, management and affairs and corporate actions requiring stockholder approval, including the approval of transactions involving a change in control. The interests of RWE and its affiliates may not coincide with the interests of our other stockholders or with your interests as a noteholder. We may not be able to repurchase the notes upon a change of control. Upon the occurrence of a change of control triggering event, the issuer will be required to offer to repurchase all outstanding notes at 101% of their principal amount plus accrued and unpaid interest. The source of funds for any such purchase of the notes will be available cash, cash generated from our operating subsidiaries (other than the issuer) or other sources, including borrowings, sales of assets or sales of equity. The sources of cash may not be adequate to permit the issuer (or us, pursuant to our obligations under the support agreement) to repurchase the notes upon a change of control triggering event. The issuer s failure to offer to repurchase the notes, or to repurchase notes tendered following a change of control triggering event, will result in a default under the indenture governing the notes, which could lead to a cross-default under the terms of our existing and future indebtedness. For further information, see Description of the Notes. Table of Contents The right of a deceased beneficial owner s representative to redeem notes may be limited in amount. The representative of a deceased beneficial owner of notes will have the right at any time to request redemption of all or part of such notes. We will have a discretionary right, however, to limit the aggregate principal amount of notes subject to redemption by the representative of any individual deceased beneficial owner of notes to $25,000 for the period prior to December 1, 2009 and each 12-month period thereafter while the notes remain outstanding. We will also have a discretionary right to limit the aggregate principal amount of notes we will redeem pursuant to such requests from all representatives of deceased beneficial owners of notes to $1,500,000 (2% of the aggregate principal amount of the notes sold in this offering) during each such period. Accordingly, we cannot assure you that a redemption request submitted by a representative of a deceased beneficial owner of notes will be permitted for the desired amount during any single period during which these limitations are calculated. In addition, any such redemptions will be effected on a quarterly basis and the right of a representative of a deceased beneficial owner of notes to request redemption of notes is subject to other conditions as described under Description of the Notes Limited Right of Redemption Upon Death of Beneficial Owner. Table of Contents

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+RISK FACTORS An investment in shares of our common stock is highly speculative and involves a high degree of risk. We face a variety of risks that may affect our operations or financial results and many of those risks are driven by factors that we cannot control or predict. Before investing in our common stock you should carefully consider the following risks, together with the financial and other information contained in this prospectus. If any of the following risks actually occurs, our business, prospects, financial condition and results of operations could be materially adversely affected. In that case, the trading price of our common stock would likely decline and you may lose all or a part of your investment. Only those investors who can bear the risk of loss of their entire investment should participate in this offering. Risks Related to Our Business and the Wind Energy Industry We have limited experience in completing development of wind parks and no operating history as an owner-operator of wind parks. To date we have developed and sold only two wind parks. We plan to continue to sell developments as a part of our ongoing business, but we intend to shift the focus of our business towards ownership and operation of merchant wind parks that we develop. We have no history as an owner-operator of wind parks from which you can evaluate our business plan, and our past performance cannot be taken as indicative of future results, especially as we change our business strategy. As we transition from being only a developer to being a developer-owner-operator of wind energy projects, our success will depend on our ability to take on those additional roles and to manage the challenges that the growth of our business will entail. Our organization has to date consisted of a small number of employees. We will be required to commence and manage significant operations, to manage growth in personnel and operations and to manage our costs as we expand our business. Our failure or inability to meet these challenges could have a material adverse effect on our business, financial condition and results of operations. The growth of our business depends upon our ability to convert our pipeline of projects under development into operating projects. We currently do not own or operate any wind parks (and therefore have no megawatts of capacity in operation). We may not be successful in completing our pipeline of development projects as anticipated or at all. Our portfolio of wind energy projects includes approximately 618 megawatts of capacity in various stages of development. (See Description of Business. ) We expect to start construction on one 20 megawatts project in 2009. Our goal is to have approximately 120 megawatts of owned operating capacity by the end of 2010, and we target the construction and commissioning of approximately 200 megawatts annually thereafter to achieve approximately 700 megawatts of owned operating capacity by the end of 2013. However, there can be no assurance we will achieve these goals. The development and construction of wind energy projects involves numerous risks and uncertainties, including: access to liquid independent systems operator markets or negotiation of power purchase agreements, availability of transmission lines with adequate capacity, obtaining necessary land rights, turbine procurement, availability of turbine, construction and permanent financing, extension of the renewable energy federal production tax credits beyond December 31, 2009, obtaining necessary governmental and regulatory approvals and permits, and negative public or community response, many of which are subject to intense competition and all of which may be beyond our control. We discuss each of these risks in additional detail below. These risks and uncertainties may prevent projects from progressing to construction and may cause us to fail to meet the targets of our development plan. We may be unable to secure the project financing required to construct the projects currently in our portfolio. If we fail to secure the project financing required for construction of these wind parks ($1.8-$2 million per megawatt of generating capacity), then Crownbutte will be relegated to being a green-field developer of prospective wind farm sites, whose income options will be limited to selling the development rights for those sites to entities that are capable of assembling the project financing required to construct, own, and operate wind farms. In such a case, Crownbutte s financial position and prospects for income would be significantly impaired. The possibility of our failure to secure project finance therefore makes investment into Crownbutte risky. We may elect not to proceed with projects currently in our portfolio. We may elect not to proceed with projects currently in our portfolio. Our current portfolio of approximately 618 megawatts in development (we have no megawatts in operation) does not include projects representing 30 megawatts of prospective capacity that we have, since 2000, actively developed and then elected not to pursue. To date costs incurred with respect to projects we have elected not to pursue have been minimal, but this may not always be the case. Our revenues may be inconsistent, creating a liquidity risk. Until we make the transition to owner/operator, our revenues depend on making a small number (one to two transactions per year) of sales of the development rights to park in our pipeline. The negotiation and lead-time to completing such transactions are not easily predictable, and may not occur at the prices or on the timing we desire. Revenues therefore can be zero for extended periods, which can result in significant liquidity risk for the company. Development of our projects depends on access to liquid independent systems operator markets We do not plan to enter into power purchase agreements unless they are offered on favorable terms. Our business model focuses on the development of merchant parks, which sell electricity into a power spot market. There are several systems that provide real time and day-ahead spot markets for electricity such as Midwest Independent Transmission System Operator, PJM, Electric Reliability Council of Texas and California Independent System Operator. Our portfolio of projects is located predominately in the Midwest, and therefore our merchant projects would sell into the Midwest Independent Transmission System Operator s spot market. It is possible that the Midwest Independent Transmission System Operator spot market becomes illiquid due to withdrawal of its member system owners, problems in the physical transmission infrastructure, or fundamental changes in the supply or demand of electricity. In the event that the spot market no longer functions efficiently, any income streams from the sale of electricity would have a material adverse effect on Crownbutte s financial condition and operations. We will depend on the availability of transmission lines with adequate capacity. We expect to generally depend on electric transmission lines owned and operated by third parties to deliver the electricity we will sell. Some of our wind energy projects in development may have limited access to interconnection and transmission capacity. The Midwest Independent Transmission System Operator will inform Crownbutte in such cases during the feasibility studies and systems impact studies that are part of the Interconnection Agreement process. We may not be able to secure access to the limited available interconnection or transmission capacity at reasonable systems upgrade cost, or at all. Since this Interconnection Agreement must be in place before any construction or turbine costs are incurred, this is a moderate financial risk for Crownbutte. However, in the event of a failure in the transmission facilities after a project is completed, we may experience lost revenues. In addition, transmission limitations may cause us to curtail our production of electricity, impairing our ability to fully capitalize on the particular wind energy project s potential. Any such failure could have a material adverse effect on our business, financial condition or results of operations. The growth of our business depends on locating and obtaining control of suitable operating sites. Wind energy projects require wind conditions that are found in limited geographic areas and particular sites. Further, wind energy projects must be interconnected to electricity transmission or distribution networks in order to deliver electricity. Once we have identified a suitable operating site, our ability to obtain requisite land control or other land rights (including access rights, setback and/or other easements) with respect to the site is subject to growing competition from other wind energy producers that have sufficient financial capacity to research, locate and obtain control of such sites and to obtain required electrical interconnection rights. Our competitors may impede our development efforts by acquiring control of all or a portion of a project site we desire to develop or obtaining a right to use land necessary to connect a project site to a transmission or distribution network. If a competitor obtains land rights critical to our project development efforts, we could incur losses as a result of stranded development costs. If we succeed in securing the property rights necessary to construct and interconnect our projects, such property rights must be insurable and otherwise satisfactory to our financing counterparties. Obtaining adequate property rights may delay development of a project, or may not be feasible. Any failure to obtain insurable property rights that are satisfactory to our financing counterparties would preclude our ability to obtain third-party financing and could prevent ongoing development and construction of the relevant projects. Our wind energy projects use and enjoyment of real property rights obtained from third parties may be adversely affected by the rights of lien holders and lease holders whose rights are superior to those of the grantors of these real property rights. Each of our wind energy projects is or will be located on land occupied pursuant to various easements and leases. Our rights pursuant to these easements and leases allow us to install wind turbines, related equipment and transmission lines for the projects and to operate the projects. The ownership interests in the land subject to these easements and leases may be subject to mortgages securing loans or other liens (such as tax liens) and other easement and lease rights of third parties (such as leases of oil, gas, coal or other mineral rights) that were created prior to our easements and leases. As a result, our rights under these easements or leases may be subject and subordinate to the rights of such third parties. A default by a landowner at one or more of our wind energy projects under a mortgage could result in foreclosure of the landowner s property and thereby terminate our easements and leases required to operate the projects. Similarly, it is possible that another lien holder, such as a government authority with a tax lien, could foreclose upon a parcel and take ownership and possession of the portion of the project located on that parcel. In addition, the rights of a third party pursuant to a superior lease could result in damage to or disturbance of the equipment at a project, or require relocation of project assets. If any of our wind energy projects were to suffer the loss of all or a portion of its wind turbines or related equipment as a result of a foreclosure by a mortgagee or other lien holder of a land parcel, or damage arising from the conduct of superior lease holders, our operations and revenues could be adversely affected. Development of wind projects is dependent on the availability of turbines and turbine financings. Wind energy projects require delivery and assembly of turbines. The prices of turbines and electrical and other equipment have increased in recent years and may continue to increase as the demand for such equipment increases more rapidly than supply, or if the prices of key components and raw materials used to build the equipment increase. We may encounter supply and/or logistical issues in securing turbines due to the limited number of turbine suppliers and current high demand for turbines. While we have received quotes from turbine suppliers and have seen some evidence of softening turbine prices and shorter delivery lead times as the financial market turmoil during the autumn of 2008 has slowed the installation of new wind capacity, we currently have no turbines under contract. We may not be able to purchase a sufficient quantity of turbines from suppliers, and suppliers may give priority to other customers. Turbine suppliers may delay the performance of or be unable to meet contractual commitments, or components and equipment may be unavailable, which would have a material adverse effect on our business, financial condition and results of operations. In addition, we expect to require third-party turbine supply loans or other financing for our turbine purchases, which account for the majority of the total cost of a wind energy project. An inability to obtain such financing on attractive terms in the future may preclude us from obtaining additional turbines, severely limiting our growth. Moreover, a significant increase in the cost of obtaining such financing could have a material adverse effect on the investment returns we achieve from our projects. In addition, spare parts for wind turbines and key pieces of electrical equipment may be unavailable to us. If we were to experience a serial failure of any spare part we would incur delays in waiting for shipment of these items to the site. In addition, we do not carry spare substation main transformers. These transformers are designed specifically for each wind energy project, and the current lead time to order this equipment is up to one year. If we have to replace any of our transformers, we would be unable to sell electricity from the affected wind energy project. When we purchase our turbines, we also enter into warranty agreements with the manufacturer. Damages payable by the manufacturer under these agreements are typically subject to an aggregate maximum cap that is a portion of the total purchase price of the turbines. Losses in excess of these caps will be our responsibility. Since our turbine warranties generally expire within a certain period of time after the turbine delivery date or the date such turbine is commissioned, we may lose all or a portion of the benefit of the warranties if we are unable to deploy turbines we have purchased upon delivery. We will need to raise additional capital to meet our business requirements, and such capital raising may be costly or difficult to obtain and could dilute current stockholders ownership interests. To date, our capital expenditures and working capital requirements have been funded by income from operations and equity capital. Our income from operations will not be sufficient to fund our business plan. We plan to raise approximately $1 million through private placements of equity, and to sell one 60 megawatts brown-field project for approximately $2 million, by the end of 2009, the proceeds of which, together with cash on hand, will be used for general corporate expenses associated with the hiring of new staff required to accelerate our development activities, as well as move into our new owner-operator business model, which requires oversight of construction of projects, as well as the operations and maintenance of projects after construction is complete. However, we may be unable to secure this additional financing on terms acceptable to us, or at all, at times when we need such financing. We do not anticipate a need to raise additional equity financing beyond this $3 million to fund development, operating and maintenance costs provided that we are able to sell to utilities or other developers one to two brown-field sites per year beginning in 2010. These fundings do not include financing of project construction and operation. See Our projects will entail significant capital expenditures and construction costs, and we will require additional financing to construct and operate them below. If we are unable to obtain such additional equity financing on a timely basis, we may have to curtail our development activities or be forced to sell assets, perhaps on unfavorable terms, which would have a material adverse effect on our business, financial condition and results of operations. We may incur substantial costs in pursuing future capital financing, including investment banking fees, legal fees, accounting fees, securities law compliance fees, printing and distribution expenses and other costs. We may also be required to recognize non-cash expenses in connection with certain securities we may issue, such as convertible notes, restricted stock, stock options and warrants, which may adversely impact our financial condition. See Management s Discussion and Analysis of Financial Condition and Results of Operations below. Any future issuance of our equity or equity-backed securities may dilute then-current stockholders ownership percentages. See You may experience dilution of your ownership interests due to the future issuance of additional shares of our common stock below. Our projects will entail significant capital expenditures and construction costs, and we will require additional financing to construct and operate them. We are in a capital intensive business, and our projects in development and construction have entailed and will entail significant capital expenditures and construction costs, and recovery of the capital investment in a wind energy project generally occurs over a lengthy period of time. The capital investment required to construct a wind energy project is primarily based on the costs of fixed assets required for the project. We will require additional financing, including tax equity financing transactions (described below), to complete the construction of and to operate our existing projects. Additional financing may not be available on acceptable terms or at all. After we have developed a wind energy project that we intend to own to the point where we are prepared to commence construction, we would expect typically to enter into a limited recourse construction loan. Proceeds from construction loans would typically be used to retire turbine indebtedness and to pay construction costs, including costs to construct roads, substations, transmission lines and the balance of plant. Construction loans are generally secured by the project s assets and our equity interests in the project companies. In certain instances we may enter into a construction loan for a single project, while in other instances we may be able to finance multiple projects through a single credit facility. We will also likely use equity capital contributions (our own and potentially from other investors as described above) to fund a portion of each project s construction costs. We would forego the need for construction loans (as well as turbine supply loans) if we are able to secure 100% debt or 100% equity-based investment for any given project. A 100% debt financing would be done on a limited recourse basis and be secured by the project assets and our equity. In a 100% equity financing, the outside equity investors would contribute all of the project costs as equity in return for an 80% to 90% share of the returns. However, while we are exploring these possibilities, these structures have not in the past been the norm in the wind generation industry and may not be available. Once construction of a wind energy project is completed and commercial operations commence, we will seek to finance the project on a long-term basis through a combination of term loans and tax equity financing. (See We expect to be materially dependent on tax equity financing arrangements below.) The unprecedented upheaval in the debt and equity markets in the U.S. and around the world in recent months has made all categories of financing more difficult to secure. In addition, the lower profits achieved by many financial institutions has made tax equity investing less available in general. See Management s Discussion and Analysis of Financial Condition and Results of Operations Project Finance. Our strategy of relying on a merchant park model may make project and tax equity financing more difficult and may adversely affect results of operations. Our business model focuses on the development of merchant parks. We do not plan to enter into power purchase agreements unless they are offered on favorable terms. Merchant parks sell electricity on the open market. The reliance on the merchant market (i.e., the lack of power purchase agreements) can be a significant barrier to achieving construction financing and project financing with tax equity investors (as described below), many of whom seek the security of long-term power purchase agreements with power off-takers. Our efforts to secure project finance have confirmed that investment banks and other financial institutions that have brokered or directly financed wind projects in the past have a continued desire to see power purchase agreements as the off-take arrangement in place for projects they seek to represent or finance. Such a desire for a power purchase agreement on the part of financiers is natural, but may not be possible to achieve by Crownbutte. There are no federal or state mandates in place that require utilities to offer power purchase agreements in North Dakota, where the bulk of Crownbutte s projects are located. Crownbutte has not, to date secured project financing for any of its parks in development. If power purchase agreements cannot be secured, and financiers decline to fund any of Crownbutte s merchant park model projects, there will be a significant adverse effect on Crownbutte s finances and operations. We expect to be materially dependent on tax equity financing arrangements. We intend to seek to secure tax equity financing to provide the majority of the permanent capital needs for each project we will own. The availability of tax equity financing depends on federal tax attributes that encourage renewable energy development. These attributes primarily include (i) renewable energy federal production tax credits, which are federal income tax credits related to the quantity of renewable energy produced and sold during a taxable year and (ii) accelerated depreciation of renewable energy assets as calculated under the Modified Accelerated Cost Recovery System of the Internal Revenue Code. We do not expect to generate sufficient taxable income from owned projects to use all of the production tax credits or the accelerated depreciation expected to be available to us under these programs. In a typical tax equity financing, we would receive a capital investment in exchange for an equity interest in our subsidiary that owns the project. These equity interests entitle the investors to receive a substantial portion of the project s cash distributions from electricity sales and related hedging agreements, production tax credits and taxable income or loss until such investors reach an agreed rate of return on their investment. As a result, a tax equity financing substantially reduces the cash distributions from the applicable projects available to us for other uses, and the period during which the tax equity investors receive cash distributions from electricity sales and related hedging agreements may last longer than expected if our wind energy projects perform below our expectations. Moreover, there are a limited number of potential tax equity investors, they have limited funds and wind energy developers compete with other renewable energy developers and others for tax equity financing. To date, the wind industry s tax equity investors have been large financial institutions with significant taxable income. The unprecedented upheaval in the debt and equity markets in the U.S. and around the world in recent months has resulted in lower profits for many financial institutions, making tax equity investing less available in general. Furthermore, as the renewable energy industry expands, the cost of tax equity financing may increase and there may not be sufficient tax equity financing available to meet the total demand in any year. If we are unable to enter into tax equity financing agreements with attractive pricing terms or at all, we may not be able to use the tax benefits provided by production tax credits and accelerated tax depreciation, which could have a material adverse effect on our business, financial condition and results of operations. In addition, our tax equity financing agreements are expected to provide our tax equity investors with a number of approval rights with respect to the applicable project or projects, including approvals of annual budgets, indebtedness, incurrence of liens, sales of assets outside the ordinary course of business and litigation settlements. As a result of these restrictions, the manner in which we conduct our business may be limited. See Management s Discussion and Analysis of Financial Condition and Results of Operations Project Finance. The growth of our business depends upon the extension of the expiration date of the production tax credit/investment tax credit, which currently expires on December 31, 2012, and other federal and state governmental policies and standards that support renewable energy development. We depend heavily on government policies supporting renewable energy that make the development and operation of wind energy projects economically feasible. In particular, we cannot economically develop and construct our pipeline of development projects without the federal production tax credit, which will expire on December 31, 2012, unless legislation is enacted to extend it. The production tax credit currently provides a $21 federal tax credit per megawatt hour for a renewable energy facility that uses wind, geothermal or closed-loop biomass fuel sources in each of the first ten years of its operation and applies to facilities that are placed in service before the end of 2012. These facilities will continue to benefit from the current production tax credit incentive until the end of the ten-year period from the date on which the wind turbines are placed in service. Without an extension of the expiration date of the production tax credit, wind energy projects may not be economically feasible to develop and construct. An option to the production tax credit is the 30% investment tax credit wherein a taxpayer may claim 30% of investment amount as a tax credit in lieu of the production tax credit. As part of the February 2009 American Recovery and Reinvestment Act, a project placed in service in 2009 or 2010 may claim a cash grant from the Treasury department instead of the investment tax credit. The grant does not constitute taxable income. In addition to the production tax credit/investment tax credit, we rely on other incentives that support the sale of energy generated from renewable sources, including state adopted Renewable Portfolio Standards programs. Renewable Portfolio Standards programs often operate in tandem with a credit trading system through which generators can buy or sell Renewable Energy Certificates that are issued by the state to generators of renewable energy to meet mandated renewable requirements. At this time, North Dakota has no Renewable Portfolio Standards, and it is not anticipated that they will have Renewable Portfolio Standards in the near future. Other states including Montana and Minnesota provide a range of incentives through Renewable Portfolio Standards programs. While federal and state governments have promoted renewable energy in the past, policies may be adversely modified or support of renewable energy development, particularly wind energy, may not continue. If governmental authorities fail to continue supporting, or reduce their support for, the development of renewable energy projects, particularly wind energy projects, it could materially adversely affect our ability to develop and construct our pipeline of development projects and grow our business. The design, construction and operation of wind energy projects are highly regulated and the failure of being granted operating and construction permits could materially adversely affect our business, financial condition and results of operations. The design, construction and operation of wind energy projects are highly regulated activities requiring various material governmental and regulatory approvals and permits. Procedures for the granting of operating and construction permits vary by jurisdiction and certain jurisdictions may deny requests for permits for a variety of reasons. Further, we may not be able to renew construction and operating permits when required. Failure to procure and maintain the necessary permits may prevent ongoing development, construction and continuing operation of our projects. In addition, in some circumstances we may have to commence construction prior to obtaining all required permits, which exposes us to the risk that we may subsequently be unable to secure all of the permits required to complete the project. If this were to occur, we could experience considerable losses as a result of our prior investment. Our projects may be subject to regulation by the Federal Energy Regulatory Commission under the Federal Power Act or other regulations that regulate the sale of electricity, which may adversely affect our business. Certain of our projects may be able to obtain qualifying facility status under the Public Utility Regulatory Policies Act, or PURPA. Qualifying facilities are exempt from certain provisions of the Federal Power Act, including the accounting and reporting requirements, and mergers and acquisitions oversight, facility disposition regulations and several other provisions of the Federal Power Act. Additionally, renewable energy facilities with a generating capacity of 30 megawatts or less are exempt from the Federal Energy Regulatory Commission's ratemaking authority under the Federal Power Act. Exempt wholesale generators are generation owning public utilities (including producers of renewable energy, such as wind projects) that are engaged exclusively in the business of owning and/or operating generating facilities and selling electric energy at wholesale. The owner of a renewable energy facility that has been certified as an exempt wholesale generator in accordance with the Federal Energy Regulatory Commission's regulations is subject to the Federal Power Act and to the Federal Energy Regulatory Commission's ratemaking jurisdiction, but the Federal Energy Regulatory Commission typically grants exempt wholesale generators the authority to charge market-based rates as long as the exempt wholesale generator can demonstrate that it does not have, or has adequately mitigated, market power and cannot otherwise erect barriers to market entry. The Federal Energy Regulatory Commission generally grants an exempt wholesale generator waivers from many of the requirements that are otherwise imposed on public utilities under the Federal Power Act. The Public Utility Holding Company Act of 2005 in part provides that any entity that owns, controls or holds power to vote 10% or more of the outstanding voting securities of a "public utility company" (which is defined to include an "electric utility company") or a company that is a "holding company" of a public utility company or public utility holding company, is subject to certain regulations granting the Federal Energy Regulatory Commission, access to books and records and oversight over certain affiliate transactions. State regulatory commissions may in some instances also have access to books and records of holding companies. However, entities that are holding companies solely by virtue of their ownership of qualifying facilities and exempt wholesale generators are exempt from most of the Public Utility Holding Company Act requirements. We intend that each of our wind parks will file a self-certification with the Federal Energy Regulatory Commission that it is an exempt wholesale generator. As a result, under current federal law, we would not be subject to regulation as a holding company under Public Utility Holding Company Act and would not be subject to this regulation as long as each "public utility company" in which we have an interest is (i) a qualifying facility, (ii) an exempt wholesale generator or (iii) subject to another exemption or waiver. Although the sale of electric energy has been to some extent deregulated, the industry is subject to increasing regulation and even the threat of re-regulation. Due to major regulatory restructuring initiatives at the federal and state levels, the U.S. electric industry has undergone substantial changes over the past several years. We cannot predict the future design of wholesale power markets or the ultimate effect ongoing regulatory changes will have on our business. Other proposals to re-regulate may be made and legislative or other attention to the electric power market restructuring process may delay or reverse the movement towards competitive markets. If the deregulation of the electric power markets is reversed, discontinued or delayed, our business prospects and financial results could be negatively affected. See Business Regulation for more information. Negative public or community response to wind energy projects may adversely affect our ability to construct our projects. There has been negative public and/or community response to wind energy projects in some areas of the United States, and such factors may adversely affect our ability to construct our projects in certain areas. In addition, legal challenges may result in an injunction against construction or operation, impeding our ability to place projects in operation according to schedule, meet our development and construction targets or generate revenues. An increase in opposition to the granting of permits or unfavorable outcomes of such challenges could materially and adversely affect our development plans. Projects that reach construction may not be completed or, if completed, may not meet our return expectations. Those projects that do progress to construction may not be completed on a timely basis or at all or, if completed, may not meet our return expectations, due to factors such as: schedule delays, cost overruns, failure to receive turbines or other critical components and equipment from third parties on schedule and according to design specifications unsatisfactory completion of construction, shortfalls of anticipated capacity factor, adverse weather, lower natural gas prices, lower than forecast spot electricity prices, and force majeure or other events out of our control. Any of the above factors could give rise to construction delays and construction costs in excess of our budgets, which could prevent us from completing construction of a project, cause defaults under our financing transactions and impair our business, financial condition and results of operations. In a situation where a power purchase agreement is in place, if we fail to construct a wind energy project in a timely manner or do not deliver electricity in accordance with the applicable power purchase agreement, the power purchase agreement may be terminated and/or we could be required to pay liquidated damages. Wind energy project revenues are highly dependent on suitable wind and associated weather conditions. The energy and revenues generated at a wind energy project are highly dependent on climatic conditions, particularly wind conditions, which are variable and difficult to predict. Turbines will only operate within certain wind speed ranges that vary by turbine model and manufacturer, and there is no assurance that the wind resource at any given project site will fall within such specifications. When we develop a wind energy project, we evaluate the quality of the wind resources at the selected site through a number of means, and we retain third-party experts to assist us in this evaluation. We base our investment decisions with respect to each wind energy project on the findings of wind studies conducted on-site before starting construction. We use the wind data that we gather to develop projections of the wind energy project s performance, revenue generation, operating profit, debt capacity, tax equity capacity and return on investment, which are fundamental elements of our business planning. Wind resource projections at the start of commercial operations can also have a significant impact on the amount of third-party capital that we can raise, including the expected contributions by tax equity investors. However, actual climatic conditions at a project site, particularly wind conditions, may not conform to the findings of these wind studies, and, therefore, our wind energy projects may not meet anticipated production levels, which could adversely affect our forecasted profitability. In addition, global climate change could change existing wind patterns; such effects are impossible to predict. Inaccurate wind resource projections on the performance of one or more of our wind energy projects resulting in unfavorable projected net capacity factor levels, could materially adversely affect our business, financial condition and results of operations. We project the net annual capacity factor for each project in our development portfolio. Net capacity factor is one element used in measuring the productivity of a wind turbine, wind energy project or any other power production facility. It compares the turbine s production over a given period of time with the amount of power the turbine could have produced if it had run at full capacity for the same amount of time. Net Capacity Factor = Amount of power produced over time (usually measured annually) Power that would have been produced if turbine operated at full capacity 100% of the time over the same period of time Our net capacity factor projections are subject to change and are not intended to predict the wind at any specific time over the turbine s 20-year useful life. Even if our predictions of a wind energy project s net capacity factor become validated over time, the energy projects may experience hours, days, months, and even years that are below our wind resource projections. Projections of net capacity factor depend on wind resource projections, which rely upon assumptions such as wind speeds, interference between turbines, effects of vegetation and land use and terrain effects. The amount of electricity generated by a wind energy project depends upon many factors in addition to the quality of the wind resource, including turbine performance, aerodynamic losses resulting from wear on the wind turbine, degradation of turbine components, icing and the number of times an individual turbine or entire wind energy project may need to be shut down for maintenance or to avoid damage. In addition, conditions on the electrical transmission network can affect the amount of energy we can deliver to the network. Wind energy projects in our portfolio may fail to meet our energy production expectations in any given time period. If our wind energy projections are not realized, we could face a number of material issues, including: our energy sales may be significantly lower than we forecast; our energy hedging arrangements may be adversely affected; we may not produce sufficient energy to meet our forward Renewable Energy Certificate sales and, as a result, we may have to buy Renewable Energy Certificates on the open market to cover our position; we may earn fewer production tax credits than projected, which would increase the period during which we must make certain distributions and allocations to our tax equity investors; and our wind energy projects may not generate sufficient cash flow to make payments on principal and interest as they become due on our project related debt. If, as a result of inaccurate wind resource projections, the performance of one or more of our wind energy projects falls below our projected net capacity factor levels, our business, financial condition and results of operations could be materially adversely affected. Volatile natural gas prices may adversely impact the market price for electricity. Natural gas is one of the major sources of energy for the generation of electricity in the U.S. The prices for natural gas have been very volatile in recent months and years, with temporary highs in June-July of 2008 that were four times the prices in January 2002. Since June, the prices for natural gas used in electricity generation have fallen back to levels seen in December 2007 and January 2008. It is not possible to reliably predict what the price behavior for natural gas will be in the future. If prices continue to fall, they will adversely impact the economics for wind power, since natural gas-based generation is one of the chief competitors to wind energy. While there can be no assurance, in the long term we expect that the continuing need to control greenhouse gas emissions, and the fact that all fossil fuels are a finite resource, will allow wind power to continue to compete favorably with natural gas. A sustained decline in market prices for electricity may materially adversely affect our revenues and the growth of our business. We may not be able to develop or operate our pipeline of development projects economically if there is a sustained material decline in market prices for electricity. Electricity prices are affected by various factors and may decline for many reasons that are not within our control, including changes in the cost or availability of fuel, regulation and acts of governments and regulators, changes in supply of generation capacity, changes in power transmission or fuel transportation capacity, seasonality, weather conditions and changes in demand for electricity. In addition, other power generators may develop alternative technologies to produce power, including fuel cells; clean coal and coal gasification; micro turbines; photovoltaic (solar) cells or tidal current based generators, or improve upon traditional technologies and equipment, such as more efficient gas turbines or nuclear or coal power plants with simplified and safer designs, among others. Advances in these or other technologies could cause a sustained decline in market prices for electricity. If there is a sustained decline in the market prices of electricity, we may not develop and construct our pipeline of development projects and grow our business, and/or we may not be able to operate completed projects economically, which would have a material adverse effect on our revenues. While we will explore the viability of hedging against the possible drop of local electricity prices, in our anticipated spot market solid hedging instruments (with high correlations to the local power market price histories) may not be available, which would represent an overall risk to the success of the business model, and is a possible barrier to achieving project financing. The continuing U.S. recession will adversely affect the price of electricity in the near term. As the U.S. continues in recession, all prices in the economy, including the price of electricity, will experience downward pressure. To the extent that Crownbutte intends to use open market venues (i.e. the merchant markets) to sell power, variability of electricity prices are a risk to profitability in the short term. Over the long term, the demand for electricity is driven by the number of consumers, the numbers of electricity-powered devices employed and the efficiency of those devices. A sustained decline in market prices for Renewable Energy Certificates may materially adversely affect our revenues and the growth of our business. Similarly, if there is a sustained material decline in Renewable Energy Certificates prices, we may not be able to achieve expected revenues, which would have an adverse effect on the investment returns on our projects. A Renewable Energy Certificate is a stand-alone tradable instrument representing the attributes associated with one megawatt hour of energy produced from a renewable energy source. These attributes typically include reduced air and water pollution, reduced greenhouse gas emissions and increased use of domestic energy sources. Many states use Renewable Energy Certificates to track and verify compliance with their Renewable Portfolio Standards ( RPS ) programs, which vary among states, but generally require power suppliers to provide a minimum percentage or base amount of electricity from specified renewable energy sources for a given period of time. Retail energy suppliers can meet the requirements by purchasing Renewable Energy Certificates from renewable energy generators, in addition to producing or acquiring the electricity from renewable sources. Our hedging strategy may not adequately manage our commodity price risk, may expose us to significant losses and may limit our ability to benefit from higher electricity prices. Our ownership and operation of wind energy projects will expose us to volatility in market prices of electricity and Renewable Energy Certificates. In an effort to stabilize our returns from electricity sales, we intend to carefully review the electricity sale options for each of our development projects. As part of this review, we will assess the appropriateness of entering into a fixed price power purchase agreement and/or a financial hedge. If we sell our electricity into a liquid independent systems operator market, we may enter into a financial hedge with institutional investors in order to stabilize our projected revenue stream. Under the terms of our anticipated financial hedges, we would not be obligated to physically deliver or purchase electricity, but we would receive payments for certain quantities of electricity based on a fixed price and would be obligated to pay the market electricity price for the same quantities of electricity. Thus, if market prices of electricity increase, we are obligated to make payments under these financial hedges. Our financial hedges will cover quantities of electricity that we estimate we can produce with a high degree of certainty. As a result, gains or losses under the financial hedges should be offset by decreases or increases in our revenues from spot sales of electricity in liquid independent systems operator markets. However, the actual amount of electricity we generate from operations may be materially different from our estimates for a variety of reasons, including variable wind conditions, catastrophic events such as fires, earthquakes, storms and changes in weather patterns due to climate change. To the extent actual amounts produced fall short of the quantities covered in our financial hedges, we will not be hedged and we will be exposed to commodity price risk. In the event a project does not generate the amount of electricity covered by the related hedge, we could incur significant losses under the financial hedge if electricity prices rise substantially above the fixed prices provided for in the hedge. If a project generates more electricity than is covered by the relevant hedge, the excess production will not be hedged and the revenues we derive will be subject to market price fluctuations. We may seek to sell forward a portion of our Renewable Energy Certificates in an effort to hedge against future declines in Renewable Energy Certificate prices. If our projects are unable to generate the amount of electricity required to earn the Renewable Energy Certificates sold forward or if we are unable for any reason to qualify our electricity for Renewable Energy Certificates in relevant states, we may incur significant losses. We may be required to post cash collateral and issue letters of credit for obligations under hedging arrangements, which may not be available on acceptable terms and if available would reduce our capacity to borrow for other purposes. Our inability to effectively manage market risks and our hedging activities may have a material adverse effect on our business, financial condition or results of operations. In addition, our hedging activities may also limit our ability to realize the full benefit of increases in electricity prices and Renewable Energy Certificates. See Management s Discussion and Analysis of Financial Condition and Results of operations Hedging. We will be dependent upon the continued and uninterrupted operation of a limited number of operating wind parks in a limited geographic area. We intend to shift the focus of our business towards ownership and operation of merchant wind parks, but we currently have no owned wind energy projects in operation, and we anticipate having only a limited number of wind parks in operation over the next two years. As a result, in future our operations may be subject to material interruption if any of our wind parks is damaged or otherwise adversely affected by one or more accidents, severe weather or other natural disasters. Tornados, lightning strikes, floods, severe storms, wildfires or other exceptional weather conditions or natural disasters could damage our wind energy projects and related facilities and decrease production levels. These events could have a material adverse effect on our revenues, particularly to the extent that they affect multiple wind energy projects and project sites. In addition, a majority of our planned wind parks will be located in the three-state region of North Dakota, South Dakota and Montana. If any of our future operating wind parks experiences material interruptions or if the regulatory environment or energy market characteristics in these states were to change in a manner adverse to us, it could have an adverse effect on our business, results of operations and financial condition. Factors beyond our control could cause us to experience increased costs with respect to our wind energy projects. Factors such as: increases in the costs of labor or materials, higher than anticipated financing costs for our wind energy projects, non-performance by third-party suppliers or subcontractors, turbine breakdowns, electricity network and other utility service failures, and major incidents and/or catastrophic events, such as fires, earthquakes or storms, may cause us to experience increased costs with respect to our wind energy projects and have a material adverse effect on our business, financial condition and results of operations. The cost of repairing or replacing damaged equipment may be considerable, and repeated or prolonged interruption may result in termination of contracts, litigation and substantial damages or penalties for regulatory or contractual non-compliance, reduced cash flows and increased financing costs. Moreover, these amounts may not be recoverable under insurance policies or contractual claims and, in relation to network failures, network service providers and market operators may also benefit from contractual limitations of liability, which would reduce any recovery of damages from them. In addition, our wind turbines and associated equipment will also require routine maintenance in order to continue to function properly. If the level of maintenance and capital expenditure exceeds our projected or contracted level, the cash flow available from the projects will be reduced, which may have an adverse impact on our results of operations and financial condition. Our key suppliers may experience technical issues with their wind turbine technology. Wind turbine technology is constantly changing and improving, and it is possible that turbine types installed by us may become obsolete. In addition, as turbine manufacturers expand or are purchased by another company, support of existing turbine models may cease. Supplier-related deficiencies may result in a prolonged shutdown of a number of turbines. In addition, a failure of performance may adversely affect our ability to arrange and close turbine supply loans, tax equity financing transactions or construction loans involving turbines. Moreover, turbine suppliers may not be able to fund the obligations they may owe us or their other customers under outstanding warranty agreements. We expect to rely on a limited number of key customers. We do not plan to enter into power purchase agreements unless they are offered on favorable terms. However, to the extent we do enter into power purchase agreements, we expect to depend on sales of electricity under those power purchase agreements to a limited number of utilities. We also expect to depend on sales of Renewable Energy Certificates to certain key customers and on electricity marketing agreements with a limited number of system owners and power marketing firms. Our operations will be highly dependent upon such customers and marketers fulfilling their contractual obligations under their agreements with us. Our customers may not comply with their contractual payment obligations or may become subject to insolvency or liquidation proceedings during the term of the relevant contracts, and the credit support received from such customers may not be sufficient to cover our losses in the event of a failure to perform. An inability or failure by such customers to meet their contractual commitments or insolvency or liquidation of our customers could have a material adverse effect on our business, financial position and results of operations. We will use utilities or power marketing firms to dispatch electricity from any projects that do not have a power purchase agreement. These firms will act as an intermediary between us and system operators, such as Midwest Independent Transmission System Operator, who act as market makers for electricity pricing. The failure or inability of these firms to properly sell our electricity into the open market may lead to lower than expected project revenues. Our development activities and operations are subject to environmental regulation and risks from environmental hazards. We are subject to various safety, environmental and natural resource protection laws and regulations in each of the jurisdictions in which we operate. These laws and regulations require us to obtain and maintain permits and approvals, undergo environmental review processes and implement required environmental, health and safety programs and procedures to control risks associated with the siting, construction, operation and decommissioning of wind energy projects. We cannot predict whether all permits required for a given project will be granted, whether the conditions associated with such permits will be achievable or whether such permits will be the subject of significant opposition. The denial of a permit essential to a project or the imposition of conditions with which it is not practicable or feasible to comply could impair or prevent our ability to develop a project. Significant opposition and delay in the environmental review and permitting process also could impair or delay our ability to develop a project. If we fail to comply with our permits, we may be required to pay fines or curtail production at our facilities. Violations of environmental laws in certain jurisdictions, including with respect to certain violations of laws protecting migratory birds and endangered species, may also result in criminal penalties. We have incurred and will continue to incur capital and operating expenditures and other costs in the ordinary course of business in complying with safety and environmental laws and regulations in the jurisdictions in which we operate. In addition, we may incur costs outside of the ordinary course of business to compensate for any environmental harm caused by our facilities, which may have a material adverse effect on our business, financial condition and results of operations. Operation of wind parks may expose us to liability for injury to persons or property. The nature of wind turbines as large rotating machinery, as well as the presence of high voltage electrical systems, may result in personal injury and loss of life and severe damage to or destruction of property and equipment, which could result in suspension or termination of operations as well as the imposition of civil or criminal penalties. We are not able to insure against all potential risks and may become subject to higher insurance premiums. In addition to potential liability for injury to persons or property, our business is exposed to many other risks inherent in the construction and operation of wind energy projects, such as breakdowns, manufacturing defects, natural disasters, terrorist attacks and sabotage. We are also exposed to environmental risks. We have obtained insurance policies to cover certain risks associated with our existing business as a turn-key developer. We believe we will be able to obtain insurance with respect to our proposed activities as an owner-operator of wind parks with coverages and limits customary for similarly situated businesses, but there can be no assurance that such insurance will be or will remain available at rates that are economic or at all. Failure to obtain insurance may hinder or prohibit our ability to secure project financing. Our existing insurance policies cover, and we would expect future policies to cover, losses as a result of force majeure , and natural disasters, but not terrorist attacks and sabotage. In addition, our insurance policies are and will be subject to annual review by our insurers, and these policies may not be renewed at all or on similar or favorable terms. If we were to incur a serious uninsured loss or a loss significantly exceeding the limits of our insurance policies, the results could have a material adverse effect on our business, financial condition and results of operations. The loss of one or more members of our senior management or key employees may adversely affect our ability to implement our strategy. We depend on our skilled and experienced management team, including Timothy H. Simons, our Chief Executive Officer. We would be materially adversely affected in the event that the services of Mr. Simons or other management or key personnel for any reason ceased to be available and adequate replacement personnel were not found. We have not obtained key-man insurance on the life of Mr. Simons. Such insurance may not be available in the future on terms acceptable to us, and there can be no assurance we will be able to secure such insurance. We also depend on our ability to attract qualified new employees in order to meet our business objectives. If we lose a member of the management team or a key employee, we may not be able to replace him or her. Integrating new employees into our management team could prove disruptive to our daily operations, require a disproportionate amount of resources and management attention and ultimately prove unsuccessful. An inability to attract and retain sufficient technical and managerial personnel could limit or delay our development efforts, which could have a material adverse effect on our business, financial condition and results of operations. Technological changes in the energy industry could render existing wind energy projects and technologies uncompetitive or obsolete. The energy industry, and especially the renewable energy industry, is rapidly evolving and is highly competitive. Technological advances may result in lower costs for sources of energy, and may render existing wind energy projects and technologies uncompetitive or obsolete. Wind parks have a long life (generally about 20 years), and cannot easily, or without substantial expense, be upgraded to new turbine technology. Our inability or failure to adopt new technologies as they are developed could have a material adverse affect our business, financial condition and results of operations. Factors over which we have little or no control may cause our operating results to vary widely from period to period, which may cause our stock price to decline. Our operating results may fluctuate significantly from period-to-period depending on several factors, including varying weather conditions; changes in regulated or market electricity prices; electricity demand, which follows broad seasonal demand patterns; changes in market prices for Renewable Energy Certificates; marking to market of our hedging arrangements and unanticipated development or construction delays. Thus, a period-to-period comparison of our operating results may not reflect long-term trends in our business and may not prove to be a relevant indicator of future earnings. These factors may harm our business, financial condition and results of operations and may cause our stock price to decline. Current or future litigation or administrative proceedings could have a material adverse effect on our business, financial condition and results of operations. Various individuals and interest groups may sue to challenge the issuance of a permit for a wind energy project or seek to enjoin construction of a wind energy project. The costs related to investigation, as well as our own internal investigation, could be significant. Unfavorable outcomes or developments relating to hypothetical proceedings or investigations, such as judgments for monetary damages and other remedies, including injunctions or revocation of permits, could have a material adverse effect on our financing plans, business, financial condition and results of operations, and we could settle claims that could adversely affect our financial position and results of operations. Requirements associated with being a public company will increase our costs significantly, as well as divert significant company resources and management attention, which could negatively impact our results of operations and/or distract management from the business of project development and financing. Prior to this offering, we have not been subject to the reporting requirements of the Exchange Act or the other rules and regulations of the Securities and Exchange Commission or any stock exchange. We will register our common stock under the Exchange Act contemporaneously with the effectiveness of the registration statement of which this prospectus is a pert. We will become a reporting company under U.S. securities laws, and we will be obliged to comply with the provisions of applicable U.S. laws and regulations, including the Securities Act, the Exchange Act and the Sarbanes-Oxley Act of 2002 and the related rules of the Securities and Exchange Commission, and the rules and regulations of the relevant U.S. market. We are working with our legal, independent accounting and financial advisors to identify those areas in which changes should be made to our financial and management control systems to manage our growth and fulfill our obligations as a public company. These areas include corporate governance, corporate control, internal audit, disclosure controls and procedures, financial reporting and accounting systems. We have made, and will continue to make, changes in these and other areas. Preparing and filing annual and quarterly reports and other information with the Securities and Exchange Commission, furnishing audited reports to stockholders and other compliance with these rules and regulations will involve a material increase in regulatory, legal and accounting expenses and the time and attention of management, and there can be no assurance that the Company will be able to comply with the applicable regulations in a timely manner, if at all. In addition, being a public company could make it more difficult or more costly for us to obtain certain types of insurance, including directors and officers liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. Applicable regulatory requirements, including those contained in and issued under the Sarbanes-Oxley Act, may make it difficult for us to retain or attract qualified officers and directors, which could adversely affect the management of our business and our ability to obtain or retain listing of our common stock. We may be unable to attract and retain those qualified officers, directors and members of board committees required to provide for effective management because of the rules and regulations that govern publicly held companies, including, but not limited to, certifications by principal executive and financial officers. The enactment of the Sarbanes-Oxley Act has resulted in the issuance of a series of rules and regulations and the strengthening of existing rules and regulations by the Securities and Exchange Commission, as well as the adoption of new and more stringent rules by the stock exchanges. The perceived increased personal risk associated with these changes may deter qualified individuals from accepting roles as directors and executive officers. Further, some of these changes heighten the requirements for board or committee membership, particularly with respect to an individual s independence from the corporation and level of experience in finance and accounting matters. We may have difficulty attracting and retaining directors with the requisite qualifications. If we are unable to attract and retain qualified officers and directors, the management of our business and our ability to obtain or retain listing of our common stock on any stock exchange (assuming we elect to seek and are successful in obtaining such listing) could be adversely affected. Risks Related to Our Securities There is not now, and there may not ever be, an active market for our common stock. There is not now, and there may not ever be, an active market for our common stock. The common stock is quoted only on the pink sheets, not on the OTC Bulletin Board, and trading of our common stock may be extremely sporadic. For example, several days may pass before any shares may be traded. As a result, an investor may find it difficult to dispose of, or to obtain accurate quotations of the price of, the common stock. Currently no broker or dealer makes a market in our common stock. There can be no assurance that a more active market for the common stock will develop, or if one should develop, there is no assurance that it will be sustained. This severely limits the liquidity of the common stock, and would likely have a material adverse effect on the market price of the common stock and on our ability to raise additional capital. We cannot assure you that our common stock will become liquid or that it will be listed on a securities exchange. We expect the common stock to remain eligible for quotation in the pink sheets and intend to make it eligible to be traded on the OTC Bulletin Board or on another over-the-counter quotation system, though there can be no assurance that this will occur. In any case, in those venues an investor may find it difficult to obtain accurate quotations as to the market value of the common stock. In addition, if we fail to meet the criteria set forth in Securities and Exchange Commission regulations, various requirements would be imposed by law on broker-dealers who sell our securities to persons other than established customers and accredited investors. Consequently, such regulations may deter broker-dealers from recommending or selling the common stock, which may further affect the liquidity of the common stock. This would also make it more difficult for us to raise additional capital in the future. Applicable Securities and Exchange Commission rules governing the trading of penny stocks limits the trading and liquidity of our common stock, which may affect the trading price of the common stock. Our common stock is currently quoted in the pink sheets, and trades below $5.00 per share; therefore, the common stock is considered a penny stock and subject to Securities and Exchange Commission rules and regulations which impose limitations upon the manner in which such shares may be publicly traded. These regulations require the delivery, prior to any transaction involving a penny stock, of a disclosure schedule explaining the penny stock market and the associated risks. Under these regulations, certain brokers who recommend such securities to persons other than established customers or certain accredited investors must make a special written suitability determination regarding such a purchaser and receive such purchaser s written agreement to a transaction prior to sale. These regulations have the effect of limiting the trading activity of the common stock and reducing the liquidity of an investment in the common stock. Our common stock has not been publicly traded prior to this offering, and we expect that the price of our common stock may fluctuate substantially. There has not been a public market for our common stock prior to this offering. A trading market for our common stock may not develop or be liquid. If you purchase shares of our common stock from a selling stockholder in this offering, you will pay a price that was not established in the public trading markets or by us. You may not be able to resell your shares above the price you pay and may suffer a loss of some or all of your investment. Broad market and industry factors may adversely affect the market price of our common stock, regardless of our actual operating performance. Other factors that could cause fluctuations in our stock price may include, among other things: uncertainty associated with the timing of project development and completion; extension or expiration of the production tax credit and other changes in government policy; actual or anticipated variations in quarterly operating results; volatility in market prices for electricity and Renewable Energy Certificates; weather conditions that may affect our production; changes in financial estimates by us or by any securities analysts who may cover our stock or our failure to meet the estimates made by securities analysts; changes in the market valuations of other companies operating in our industry; announcements by us or our competitors of significant acquisitions, strategic partnerships or divestitures; additions or departures of key personnel; and sales of our common stock, including sales of our common stock by our directors and officers or by our other principal stockholders. We currently do not intend to pay dividends on our common stock for the foreseeable future. As a result, your only opportunity to achieve a return on your investment is if the price of our common stock appreciates. We currently do not expect to declare or pay dividends on our common stock for the foreseeable future. We expect to use future earnings, if any, to fund business growth. Therefore, stockholders will not receive any funds absent a sale of their shares. We may also enter into agreements in the future that prohibit or restrict our ability to declare or pay dividends on our common stock. As a result, your only opportunity to achieve a return on your investment will be if the market price of our common stock appreciates and you sell your shares at a profit. Securities analysts may not initiate coverage or continue to cover our common stock, and this may have a negative impact on its market price. The trading market for our common stock will depend in part on the research and reports that securities analysts publish about our business and our Company. We do not have any control over these analysts. There is no guarantee that securities analysts will cover the common stock. If securities analysts do not cover the common stock, the lack of research coverage may adversely affect its market price. If we are covered by securities analysts, and our stock is the subject of an unfavorable report, our stock price would likely decline. If one or more of these analysts ceases to cover our Company or fails to publish regular reports on us, we could lose visibility in the financial markets, which could cause our stock price or trading volume to decline. You may experience dilution of your ownership interests due to the future issuance of additional shares of our common stock. We are in a capital intensive business and we do not have sufficient funds to finance the growth of our business or the construction costs of our development projects or to support our projected capital expenditures. As a result, we will require additional funds from further financings, including tax equity financing transactions or sales of common or preferred stock, or other securities that are convertible into or exercisable for our common or preferred stock, to complete the development of new projects, fund project equity and pay the general and administrative costs of our business. We may also issue such securities in connection with hiring or retaining employees and consultants (including stock options issued under our equity incentive plans), as payment to providers of goods and services, in connection with future acquisitions or for other business purposes. Our Board of Directors may at any time authorize the issuance of additional common or preferred stock without common stockholder approval, subject only to the total number of authorized common and preferred shares set forth in our articles of incorporation. The preferences and rights of any preferred stock we issue will be as determined by our Board of Directors. The terms of equity securities issued by us in future transactions may be more favorable to new investors, and may include dividend and/or liquidation preferences, superior voting rights and the issuance of warrants or other derivative securities, which may have a further dilutive effect. The future issuance of such additional shares of common stock or preferred stock or other securities may create downward pressure on the trading price of our common stock. Any such future issuances of such additional shares of common stock or preferred stock or other securities may be at a price (have an exercise price) below the price you paid for your common stock or the price at which shares of the common stock are then traded. SELLING STOCKHOLDERS This

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+RISK FACTORS You should carefully consider all of the information contained in or incorporated by reference in this prospectus, including but not limited to, our and AMR s Annual Reports on Form 10-K for the year ended December 31, 2008 (and, in the case of AMR, as updated by AMR s Current Report on Form 8-K filed on April 21, 2009), our and AMR s Quarterly Reports on Form 10-Q for the quarters ended March 31, 2009, June 30, 2009 and September 30, 2009. In addition, you should carefully consider the risk factors described below, along with any risk factors that may be included in our future reports to the SEC. Risk

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+RISK FACTORS You should consider the "Risk Factors" included under Item 1A. of our Annual Report on Form 10-K for the fiscal year ended December 27, 2008, and under Item 1A. of our Quarterly Reports on Form 10-Q for the quarterly periods ended March 28, 2009, June 27, 2009, and September 26, 2009, which are incorporated by reference in this prospectus. The market or trading price of our securities could decline due to any of these risks. In addition, please read "Information Regarding Forward-Looking Statements" in this prospectus, where we describe additional uncertainties associated with our business and the forward-looking statements included or incorporated by reference in this prospectus. Please note that additional risks not currently known to us or that we currently deem immaterial may also impair our business and operations.

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+RISK FACTORS An investment in our common stock is speculative in nature, involves a high degree of risk, and should not be made by an investor who cannot bear the economic risk of its investment for an indefinite period of time and who cannot afford the loss of its entire investment. You should carefully consider the following risk factors and the other information contained elsewhere in this prospectus before making an investment in our common stock. Risks Relating to Our Business We have a history of significant and continued operating loses and a substantial accumulated earnings deficit, and we may continue to incur significant losses and never achieve profitability. We have incurred significant net losses every year since our inception, including net losses of $1,308,902 for the year ended September 30, 2008 and $1,968,242 for the nine months ended September 30, 2007. As of September 30, 2008, we had an accumulated deficit of $10,494,423. To achieve profitability, we will need to generate and sustain substantially higher revenues than we have to date while achieving reasonable cost and expense levels. We may not be able to generate enough revenue to achieve profitability. Even if we become profitable, we may not be able to sustain or increase profitability on a quarterly or annual basis. We require substantial amounts of cash to implement our aggressive marketing plans and to operate our business, and there can be no assurance that we will have the amount of capital necessary or be able to accurately predict our capital requirements therefor. We have aggressive marketing plans that require us to spend substantial sums. We will need additional capital to continue our business plan. In addition, we may not accurately predict the amount of capital it requires to operate our existing and future business, which requirement may exceed our estimates, and there can be no assurance we will have access to adequate amounts of capital to service such needs. Our failure to accurately predict future capital requirements and to secure additional financing may have a material adverse affect on our ability to operate our business and implement our strategy and adversely affect our ability to grow. We may not be able to secure financing needed for future operating needs on acceptable terms, or on any terms at all. From time to time, we may seek additional financing to provide the capital required to maintain or expand our facilities, implement our marketing plans and operate our business, as well as to repay outstanding loans if cash flow from operations is insufficient. If such financing is not available on satisfactory terms, we may be unable to expand our business or develop new business at the desired rate. Consequently, our operating results may suffer. If we are able to incur debt, we may be subject to certain restrictions imposed by the terms of the debt and the repayment of such debt may limit our cash flow and our ability to grow. If we are unable to incur debt, we may be forced to issue additional equity, which could have a dilutive effect on our current stockholders. Table of Contents We have experienced fluctuations in our quarterly operating results, due to numerous factors, and anticipate that these fluctuations will continue, which may have a material adverse affect on our ability to operate and grow our business. Predicting operating results has proven to be difficult due to frequently encountered expenses and delays. Our operating results may vary significantly, depending on a number of factors, including, but not limited to: changes in reimbursement guidelines and amounts; changes in regulations affecting the healthcare industry; changes in the mix or cost of our products; the timing of customer orders; the timing and cost of our advertising campaigns; and the timing of the introduction or acceptance of new products and services offered by us or our competitors. Our failure to accurately predict our quarterly operating results may have a material adverse effect on our ability to operate and grow our business. Our existing indebtedness may adversely affect our ability to obtain additional funds and may increase our vulnerability to economic or business downturns. Our indebtedness aggregated approximately $6.8 million as of September 30, 2008. As a result, we are subject to the risks associated with significant indebtedness, including: we must dedicate a portion of our cash flows from operations to pay debt service costs and, as a result, we have less funds available for operations and other purposes; it may be more difficult and expensive to obtain additional funds through financings, if available at all; we are more vulnerable to economic downturns and fluctuations in interest rates, less able to withstand competitive pressures and less flexible in reacting to changes in our industry and general economic conditions; and if we default under any of our outstanding notes or if our creditors demand payment of a portion or all of our indebtedness, we may not have sufficient funds to make such payments. We have restated the statement of operations for the three and six months ended June 30, 2007 and 2006, and the balance sheet for June 30, 2007 to reflect various corrections, and no assurance can be given that similar restatements will not be required in the future. We have restated our financial statements as of and for the three and six months ended June 30, 2007 to reflect various corrections of certain errors. While we believe we have put processes in place to begin to remedy areas in our internal controls, no assurances can be given that we will not be faced with situations which may require us to restate our financial statements again. Any such restatements could adversely affect the credibility of our reported financial results and the price of our common stock. Table of Contents If our customers are unable to receive reimbursement from third parties, including Medicare, our growth and revenues will be materially and adversely affected in markets where our customers rely on insurance coverage for payment. Sales of a significant portion of our products depend on the continued availability of reimbursement of our customers by government and private insurance plans such as Blue Cross/Blue Shield Health Insurance, Aetna Health Insurance, and United HealthCare Health Insurance. Any reduction in Medicare reimbursement currently available (due to either (i) delays, (ii) denial of reimbursement, or (iii) directions to Medicare consumers to other companies through the process of competitive bidding, governmental contracts or any kind of nationwide managed care or governmental program) for our products would reduce our revenues. Without a corresponding reduction in the cost of such products, our profit margins would be reduced. Similarly, any increase in the cost of products without a corresponding increase in Medicare reimbursement would reduce our profit margins. Further, we could experience significantly reduced profits if Medicare changes, delays or denies reimbursement or directs Medicare consumers to other companies through the process of competitive bidding, governmental contracts or any kind of nationwide managed care or governmental program. Audits or periodic investigations of our company by federal agencies, including Medicare, could lead to recoupment of monies paid to us, fines, off-sets on future payments and even loss of Medicare billing privileges, which could adversely affect our business and results of operations. The regulations that govern Medicare reimbursement are complex and our compliance with these regulations may be reviewed by federal agencies, including the Department of Health and Human Services, the Department of Justice, and the U.S. Food and Drug Administration, or the FDA. These agencies conduct audits and periodic investigations of most companies that bill Medicare, and since we perform a substantial amount of Medicare billing each year, we could be the subject of any audit or investigation at any time. Medicare audits or investigations could lead to recoupment of monies paid to us, fines, off-sets on future payments and even loss of Medicare billing privileges. Loss of these billing privileges could result in the loss of 70% to 80% of our total revenues. We regularly are audited by all four regional Medicare carriers and have, on some occasions, been required to reimburse claims previously paid to us for various reasons, such as billing errors, lack of medical records in physician offices, insufficient patient diagnoses, returns, patient s having similar equipment, patient not seen by physician recently enough and lack of adequate medical necessity. Since our inception, we have not incurred fines or penalties by Medicare. Although we have set aside reserves for potential repayments, demands for repayment could exceed our reserves and we could be unable to pay Medicare, which would adversely affect our business and our results of operations. If we are unable to effectively manage our potential growth, our business may become inefficient and we may not be able to effectively compete, increase our revenues or control our expenses. Since our inception, we have maintained staff and other operating levels intended for a business with greater revenues than we have achieved to date. We have built out and occupy 83% of the 30,000 square feet of leased premises in Stuart, Florida, to accommodate our growth and operating levels. Although we expect to hire an additional 50 employees over the course of the fiscal year ending September 30, 2009, we cannot be sure that our staffing levels will be sufficient if we expand as rapidly as we believe possible. Any expansion will create significant demands on our administrative, operational and financial personnel and other resources. Additional expansion in existing or new markets could strain these resources and increase our need for capital. Our personnel, systems, procedures, controls and existing space may not be adequate to support further expansion. Any suspension of production or sales of our products or recalls mandated by the FDA or other regulatory agencies that regulate the products we sell, could cause us to lose sales or incur additional expense, which could materially adversely affect our business and results of operations. Many of the products that we sell are regulated by the FDA and other regulatory agencies. If any of these agencies mandate a suspension of production or sales of our products or mandate a recall, we may lose sales and incur additional expenses until such products regain compliance with the regulations or we change to another Table of Contents supplier of our products. In such case, we cannot assure you that any of such products will regain or that we will be able to engage another supplier on a timely basis, if at all. We depend on a limited number of suppliers for our products, and the inability to secure our products could reduce our revenues and adversely affect our relationship with our customers. We rely on a limited number of suppliers for the products we sell. Although there are many suppliers for the products we sell, we are dependent on a limited number of suppliers for many of the significant products we sell. Coloplast Corporation and CR Bard Inc. supply approximately 38% and 19%, respectively, of our products. This reliance involves a number of significant potential risks, including, the lack of availability of products and interruptions in delivery of products to our customers and fluctuations in the quality and price of our products. We do not have any long-term or exclusive purchase commitments with any of our suppliers. Our failure to maintain existing relationships with our suppliers or to establish new relationships in the future could negatively affect our ability to obtain our products in a timely manner. If we are unable to obtain ample supply of product from our existing suppliers or alternative sources of supply, we may be unable to satisfy our customers orders, which could materially and adversely affect our revenues and our relationship with our customers. We may be exposed to product liability claims for which our product liability insurance may be inadequate. We could be liable for harm caused by products that we sell. The sale of medical products entails the risk that users will make product liability claims. A product liability claim could be expensive. While management believes that our insurance provides adequate coverage, we cannot provide any assurance that: our insurance will provide adequate coverage against potential liabilities if a product causes harm or fails to perform as promised; adequate product liability insurance will continue to be available in the future; or our insurance can be maintained on acceptable terms. The obligation to pay any product liability claim in excess of whatever insurance we are able to obtain would increase our expenses and could greatly reduce our assets. The failure to maintain our relationships with our existing customers or the failure to obtain new customers could negatively affect our revenues and decrease our earnings or have an adverse impact on our business. Our ability to operate at a profit is highly dependent on recurring orders from customers, as to which there is no assurance. We generally incur losses and negative cash flow with respect to the first order from a new customer for chronic care products and respiratory products due primarily to the marketing and regulatory compliance costs associated with initial customer qualification. Accordingly, the profitability of these product lines depends, in large part, on recurring and sustained reorders. Reorder rates are inherently uncertain due to several factors, many of which are outside our control, including changing customer preferences, competitive price pressures, and customer transition to extended care facilities, customer mortality and general economic conditions. We cannot assure that agreements with existing customers will be renewed when the terms of such agreements expire or that our relationships with our customers will be maintained on satisfactory terms, if at all. The failure to maintain our relationships with our customers or the failure to obtain new customers could negatively affect our revenues and decrease our earnings and adversely impact our business. The medical supply industry is highly competitive and if we fail to compete effectively, we may lose our market share and our profitability may be adversely affected. The medical supply industry is rapidly evolving and highly competitive. We expect competition in this market to persist and intensify. Existing or future competing companies may provide (ii) products with greater utility, lower cost or other benefits from their intended uses than our products or (ii) may offer comparable Table of Contents performance at lower cost. Many of these companies are well-established, have substantially greater financial and other resources, and have more experience in promoting and marketing products than we do. There can be no assurance that we will be able to compete successfully with such competitors. If we fail to capture and maintain market share, we may not achieve sufficient revenues and our business could suffer. Failure in our technology or telecommunications systems could significantly disrupt our operations, which could reduce our customer base and result in lost revenues. Our success depends, in part, on the continued and uninterrupted performance of our information technology and network systems as well as our customer service centers. The hardware supporting a large number of critical systems for our systems is housed in one location. Our systems are vulnerable to damage from a variety of sources, including communications failures, power loss, malicious human acts and natural disasters. Moreover, despite security measures, our servers are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems. Despite the precautions we have taken, unanticipated problems affecting our systems could cause failures in our information technology systems or disruption in our ability to serve our customers. Sustained or repeated system failures that interrupt our ability to serve our customers or otherwise meet our business obligations in a timely manner would adversely affect our reputation and result in a loss of customers and net revenue. From time to time, we may make acquisitions of businesses and cannot assure you that we will be able to successfully integrate any businesses, products, technologies or personnel that we might acquire. Any failure to do so could have a material adverse effect on our financial condition and results of operations. We regularly consider investments in complementary companies, products or technologies. In the event of any future acquisitions, we could: become unable to obtain adequate product liability insurance in the future; issue stock that would dilute our current stockholders percentage ownership; incur debt; assume liabilities; incur expenses related to the impairment of goodwill; or incur large and immediate write-offs. Our operation of any acquired business will also involve numerous risks, including: problems combining the acquired operations, technologies or products; unanticipated costs; diversion of management s time and attention from our core business; adverse effects on existing business relationships with suppliers and customers; risks associated with entering markets in which we have no or limited prior experience; and potential loss of key employees, particularly those of acquired companies. Table of Contents The loss of one or more members of our management team or other key employees could affect our operations and our ability to successfully grow our business. Our success and future growth depends to a significant degree on the skills and continued services of our management team and key players such as Mark Libratore. Mark Libratore is our President and Chief Executive Officer and our sole director. Mr. Libratore is responsible for the day-to-day management of the business. We currently maintain a $2,000,000 policy of key man insurance on Mr. Libratore s life, with respect to $1,000,000 of which we are the beneficiary and with respect to the remaining $1,000,000 of which Mr. Libratore s wife is the beneficiary. The loss of Mr. Libratore s services, either through retirement, incapacity or death, could impair our revenue growth, business and future prospects. Further, our ability to execute our business plan is dependent on our ability to attract and retain additional highly skilled personnel. Our sole director and President and Chief Executive Officer has substantial control over us, which could delay or prevent a change in our corporate control even if our other stockholders wanted it to occur. As of December 11, 2008, Mark Libratore, our sole director and President and Chief Executive Officer, held approximately 48.81% of our common stock, excluding options to purchase up to 4,021,009 shares of our common stock. As a result, Mr. Libratore has the ability to exercise substantial control over all corporate actions requiring shareholder approval, irrespective of how our other shareholders including purchasers in this offering may vote, including the following actions: the election of directors; adoption of stock option plans; the amendment of charter documents; or the approval of certain mergers and other significant corporate transactions, including a sale of substantially all of our assets. We do not have a majority of independent directors serving on our board of directors, which could present the potential for conflicts of interest. We do not have a majority of independent directors serving on our board of directors and we cannot guarantee that our board of directors will have a majority of independent directors in the future. In the absence of a majority of independent directors, our executive officers could establish policies and enter into transactions without independent review and approval thereof. This could present the potential for a conflict of interest between us and our stockholders, generally, and the controlling officers, stockholders or directors. Mark Libratore, our sole director, has outstanding notes in the principal amount of $1,664,649 as of September 30, 2008. These notes bear interest at an annual rate of 8% to 11%. Mr. Libratore has committed not to call any of his notes payable in the near future although our obligations to Mr. Libratore are payable on demand and are not collateralized. There are no assurances that we will (i) be able to repay the notes when due under the terms of the current agreement or (ii) that Mr. Libratore will not call any of his notes payable. See Certain Relationships and Related Transactions. Risks Relating to Ownership of Our Common Stock As a result of our failure to timely file our periodic reports under the Securities Exchange Act, in February 2008, our shares of common stock became ineligible to trade on the Over-the-Counter Bulletin Board, or the OTCBB and commended trading on the Pink Sheets, and as a result, the volume and market price of our common stock may be adversely affected. In January 2008, we received notice that our common stock would not be eligible for trading on the Over- Table of Contents The-Counter Bulletin Board, or the OTCBB, for a minimum period of approximately one year because we had failed to timely file our periodic reports under the Securities Exchange Act of 1934 three times in a two year period. We appealed the original notice but our appeal was rejected. Accordingly, commencing February 14, 2008, our common stock started trading on the Pink Sheets and will do so until we have filed periodic reports on a timely basis for twelve months, at which time we can reapply to have our common stock traded on the OTCBB; however, we cannot assure when, if at all, we will reapply to have our common stock traded on the OTCBB. We cannot anticipate with accuracy the effect, if any, of our securities being traded on the Pink Sheets, but expect that the volume and market price of our common shares may be adversely affected. We cannot assure you that there will be an active trading market for our common stock and it could be difficult for holders of our common stock to liquidate their shares. We cannot predict the extent to which a trading market will develop or continue in our common stock or how liquid that market might become. Also, most shares outstanding after the acquisition of Liberator Medical, including those issued pursuant to the acquisition, are deemed restricted securities within the meaning of Rule 144 promulgated by the SEC and will therefore be subject to certain limitations on the ability of holders to resell such shares. Because only a small percentage of our outstanding shares are freely tradeable in the public market, the price of our shares could be volatile and liquidation of a person s holdings may be difficult. Thus, holders of our common stock may be required to retain their shares for a long period of time. We do not anticipate paying dividends in the foreseeable future, which could make our stock less attractive to potential investors. We anticipate that we will retain any future earnings and other cash resources for future operation and development of our business and do not intend to declare or pay any cash dividends in the foreseeable future. Any future payment of cash dividends will be at the discretion of our board of directors after taking into account many factors, including our operating results, financial condition and capital requirements. Corporations that pay dividends may be viewed as a better investment than corporations that do not. Future sales or the potential for sale of a substantial number of shares of our common stock could cause our market value to decline and could impair our ability to raise capital through subsequent equity offerings. Sales of a substantial number of shares of our common stock in the public markets, or the perception that these sales may occur, could cause the market price of our common stock to decline and could materially impair our ability to raise capital through the sale of additional equity securities. In addition to the 32,050,366 shares of our common stock issued and outstanding as of December 11, 2008 (excluding shares reserved for issuance upon exercise of outstanding options, warrants and convertible notes), there are another 167,949,634 shares of authorized but unissued common stock that may be issued in the future. Anti-takeover provisions of Nevada law, our bylaws may prevent or delay an acquisition of us that shareholders may consider favorable or attempts to replace or remove our management that could be beneficial to our shareholders. Our bylaws contain provisions which could make it more difficult for a third party to acquire us without the consent of our board of directors. Our bylaws impose restrictions on the persons who may call special shareholder meetings. Furthermore, the Nevada Revised Statutes contain an affiliated transaction provision that prohibits a publicly-held Nevada corporation from engaging in a broad range of business combinations or other extraordinary corporate transactions with an interested stockholder unless, among others, (i) the transaction is approved by a majority of disinterested directors before the person becomes an interested shareholder or (ii) the transaction is approved by the holders of a majority of the corporation s voting shares other than those owned by the interested shareholder. An interested shareholder is defined as a person who together with affiliates and associates beneficially owns more than 10% of the corporation s outstanding voting shares. This provision may have the effect of delaying or preventing a change of control of our company even if this change of control would benefit our shareholders. Trading in our shares is subject to certain penny stock regulation, which could have a negative effect on the Table of Contents price of our shares in the public trading market. Public trading of our common stock on the Pink Sheets is subject to certain provisions, commonly referred to as the penny stock rules, promulgated under the Securities Exchange Act of 1934. A penny stock is generally defined to be any equity security that has a market price less than $5.00 per share, subject to certain exceptions. If our stock is deemed to be a penny stock, trading in our stock will be subject to additional sales practice requirements on broker-dealers. These require a broker dealer to: make a special suitability determination for purchasers of penny stocks; receive the purchaser s written consent to the transaction prior to the purchase; and deliver to a prospective purchaser of a penny stock, prior to the first transaction, a risk disclosure document relating to the penny stock market. Consequently, penny stock rules may restrict the ability of broker-dealers to trade and/or maintain a market in our common stock. Also, many prospective investors may not want to get involved with the additional administrative requirements, which may have a material adverse effect on the trading of our shares. If you are not an institutional investor, you may purchase our securities in this offering only if you reside within certain states and may engage in resale transactions only in those states and a limited number of other jurisdictions. If you are not an institutional investor, you will need to be a resident of certain jurisdictions to purchase our securities in this offering. The definition of an institutional investor varies from state to state but generally includes financial institutions, broker-dealers, banks, insurance companies and other qualified entities. In order to prevent resale transactions in violation of states securities laws, you may engage in resale transactions only in the states and in other jurisdictions in which an applicable exemption is available or a registration application has been filed and accepted. This restriction on resale may limit your ability to resell the securities purchased in this offering and may impact the price of our shares. If you are not an institutional investor, you generally will not be permitted to purchase shares in this offering unless there is an available exemption or we register the shares covered by this prospectus in such states. Table of Contents

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+RISK FACTORS An investment in the Company s common stock involves a high degree of risk. You should carefully consider the risks described below as well as other information provided to you in this prospectus, including information in the section of this document entitled Forward Looking Statements. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently believe are immaterial may also impair our business operations. If any of the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected, the value of our common stock could decline, and you may lose all or part of your investment. Risks Related to our Business Sales of a substantial number of shares of our common stock in the public market could cause a reduction in the market price of our common stock. Any significant downward pressure on the price of our common stock as our shareholders sell shares of our common stock could encourage short sales. Any such short sales could place further downward pressure on the price of our common stock. We have a history of operating losses and thus we may not be profitable in the future. Our continued existence is dependent upon us successfully expanding our business and attaining profitable operations. We have historically had net losses from operations and there can be no assurance that we will be profitable in the future. If we are not profitable and cannot attain sufficient capital to fund our operations we may have to cease our operations. (State or jurisdiction of incorporation or organization) (Primary Standard Industrial Classification Code Number) (I.R.S. Employer Identification No.) 5 Columbia Road, Somerville, New Jersey 08876 (908) 722-8081 (Address and telephone number of principal executive offices) Robert S. Benou 5 Columbia Road Somerville, New Jersey 08876 908 722-8081 (Name, address and telephone number of agent for service) Copies to: David B. Manno, Esq. Sichenzia Ross Friedman Ference LLP 61 Broadway, 32 nd Floor New York, New York 10006 (212) 930-9700 (212) 930-9725 (fax) Approximate date of commencement of proposed sale to the public: From time to time after the effective date of this registration statement. If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933 check the following box. x If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o (COVER CONTINUES ON FOLLOWING PAGE) We have many competitors and we may not be able to compete effectively against them. The market for our manufactured products is very competitive. There are several companies that manufacture products similar to the products we sell. Most of these companies are substantially larger than us and have substantially greater name recognition, financial resources and personnel than we do. Our success depends on keeping up with technological changes. The market for our manufactured products is characterized by rapid technological changes and advances. Our failure to continue to introduce new products in a timely or cost effective manner or our failure to continue to improve our existing products in a timely or cost effective manner would materially adversely affect our operating results, and as a result, we may not be able to compete effectively against them. We are dependent on a few large customers. Our dependence on major customers including Bonneville Power Authority, Surtek Industries, NIPSCO, Tucson Electric Power and U.S. Defense Supply Command, which accounted for an aggregate $1,078,947 or 63.7% of our total sales during the fiscal year ended July 31, 2009, subjects us to significant financial risks in the operation of our business if a major customer were to terminate or materially reduce, for any reason, its business relationship with us. We may not be able to attract the qualified personnel we need to succeed. Because of the technical nature of our business, we are dependent upon our ability to attract and retain technologically qualified personnel. Competition for individuals with proven professional or technical skills is intense, and the demand for these individuals is expected to remain very strong for the foreseeable future. Larger companies may be able to pay substantially higher salaries than we are able to pay. Therefore, we may not be successful, especially during increased economic activity, in attracting qualified personnel. Our minimal staff may have difficulty managing our operations. We only employ about 16 people on a full time basis. Approximately 8 of our full time employees are involved in production. Our success is dependent upon the services of our current management, particularly Robert S. Benou, our Chairman, Chief Executive Officer and Chief Financial Officer and Marc Benou our President, Chief Operating Officer and Secretary. Messrs. Robert Benou and Marc Benou are currently serving under employment contracts that renew on a year-to-year basis unless terminated by either party thereto upon at least 90 days notice prior to the expiration of the then current term of such agreement. If the employment of Messrs. Robert Benou or Marc Benou terminates, or if either is unable to perform his duties, we may be materially and adversely affected. We are dependent on component manufacturers to provide us with the parts we need. We are dependent on outside suppliers for all of the subcomponent parts and raw materials we need to assemble our products. A shortage, delay in delivery, or lack of availability of a part could lead to assembling delays, which could reduce sales. We also purchase some custom parts, primarily printed circuit boards. The failure of a supplier of one of these customized components could cause a lengthy delay in production, resulting in a loss of revenues. We have limited cash and may not be able to receive additional financing. As of October 31, 2009, we had approximately $455,000 cash. We believe that this, together with anticipated cash flows from operation will be sufficient to satisfy our working capital requirements for the foreseeable future. However, we may need to seek additional financing sooner than we anticipate as a result of factors including but not limited to the following: o changes in operating plans o lower than anticipated sales o increased operating costs; and o potential acquisitions However, additional financing may not be available on commercially reasonable terms, if at all. Our stock price may fluctuate, which may make it difficult to resell your shares at attractive prices. The market price of our common stock may experience fluctuations. The market price of our common stock has been volatile, and may continue to be volatile. Factors that could cause volatility in our stock price include: Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one): o Large accelerated filer o Accelerated filer x Non-accelerated filer o Smaller reporting company CALCULATION OF REGISTRATION FEE Title of Class of Securities to be Registered Amount To Be Registered Proposed Maximum Aggregate Price Per Share (1) Proposed Maximum Aggregate Offering Price Amount of Registration Fee o fluctuations in our quarterly operating results; o stock market prices and volume fluctuations generally; o economic conditions specific to any of the industries that we conduct business in; o announcements by us or our competitors relating to new services or technologies, significant acquisitions, significant orders, strategic relationships, joint ventures or capital commitments; and o applicable regulatory developments. If we are delisted from the Nasdaq Capital Market, you may also find it more difficult to trade our common stock due to penny stock rules. If we are unable to satisfy the requirements for continued quotation on Nasdaq, trading, if any, in our common stock would be conducted in the over-the-counter market in what is commonly referred to as the pink sheets or on the OTC Bulletin Board. If our shares become subject to the regulations on penny stocks, the price and ability to sell our shares would be severely affected because the shares could only be sold in compliance with the penny stock rules. The issuance of shares upon conversion of our convertible securities and exercise of outstanding warrants may cause immediate and substantial dilution to our existing stockholders. As of October 31, 2009, we had outstanding warrants to purchase 2,693,081 shares of our common stock, of which warrants to purchase 2,564,102 shares of our common stock have an exercise price of $1.12 per share, warrants to purchase 128,979 shares of our common stock have a weighted average exercise price of $3.83 per share. As of October 31, 2009, we also had outstanding convertible notes having an aggregate principal balance of $778,744 which are convertible into 998,390 shares of our common stock at a conversion price of $0.78 per share. Subject to the terms of the convertible notes we may also issue shares of our common stock to pay interest due on the convertible notes. The issuance of shares of our common stock upon the exercise of warrants or upon conversion of the notes may result in substantial dilution to the interests of other stockholders.

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+RISK FACTORS You should carefully consider the risks described below, in addition to the other information contained or incorporated by reference in this prospectus. Specifically, please see "Information Regarding Forward-Looking Statements" and "Risk Factors" included in the Annual Reports on Form 10-K for the year ended December 31, 2007 of Kinder Morgan Management, LLC and Kinder Morgan Energy Partners and their subsequently filed Exchange Act reports for a discussion of risks and events that may affect our business. You also should carefully consider the risks related to Knight Inc. described in Annex A under the caption "Risk Factors." Realization of any of those risks or events could have a material adverse effect on our business, financial condition, cash flows and results of operations. Realization of any of those or the following risks could result in a decline in the trading price of our shares, and you might lose all or part of your investment. Because our only significant assets are the i-units issued by Kinder Morgan Energy Partners, our success is dependent solely upon our operation and management of Kinder Morgan Energy Partners and its resulting performance. We are a limited partner in Kinder Morgan Energy Partners. In the event that Kinder Morgan Energy Partners decreases its cash distributions to its common unitholders, distributions of i-units on the i-units that we own will decrease correspondingly, and distributions of additional shares to owners of our shares will decrease as well. The risk factors that affect Kinder Morgan Energy Partners also affect us. Please see the risk factors described in Kinder Morgan Energy Partners' Annual Report on Form 10-K for the year ended December 31, 2007 and its subsequent Exchange Act reports, which are incorporated in this prospectus by reference. The value of the quarterly distribution of an additional fractional share may be less than the cash distribution on a common unit of Kinder Morgan Energy Partners. The fraction of a Kinder Morgan Management, LLC share to be issued per share outstanding with each quarterly distribution is based on the average closing price of the shares for the ten consecutive trading days preceding the ex-dividend date for our shares. Because the market price of our shares may vary substantially over time, the market value of our shares on the date a shareholder receives a distribution of additional shares may vary substantially from the cash the shareholder would have received had the shareholder owned common units instead of our shares. The tax treatment applied to Kinder Morgan Energy Partners depends on its status as a partnership for United States federal income tax purposes, as well as Kinder Morgan Energy Partners not being subject to a material amount of entity-level taxation by individual states. If the IRS treats Kinder Morgan Energy Partners as a corporation or Kinder Morgan Energy Partners becomes subject to a material amount of entity-level taxation for state tax purposes, it would substantially reduce the amount of cash available for distribution to common unitholders, the value of i-units that Kinder Morgan Energy Partners will distribute quarterly to us and the value of our shares that we will distribute quarterly to our shareholders. The anticipated benefit of an investment in our shares depends largely on the treatment of Kinder Morgan Energy Partners as a partnership for United States federal income tax purposes. In order for Kinder Morgan Energy Partners to be treated as a partnership for United States federal income tax purposes, current law requires that 90% or more of its gross income for every taxable year consist of "qualifying income," as defined in Section 7704 of the Internal Revenue Code. Kinder Morgan Energy Partners may not meet this requirement or current law may change so as to cause, in either event, Kinder Morgan Energy Partners to be treated as a corporation for United States federal income tax purposes or otherwise subject to United States federal income tax. Kinder Morgan Energy Partners has not requested, and does not plan to request, a ruling from the IRS on this or any other matter affecting Kinder Morgan Energy Partners. Copy to: Gary W. Orloff Bracewell & Giuliani LLP 711 Louisiana Street, Suite 2300 Houston, TX 77002-2770 (713) 221-1306 (713) 221-2166 (Fax) Table of Contents If Kinder Morgan Energy Partners were to be treated as a corporation for United States federal income tax purposes, it would pay United States federal income tax on its income at the corporate tax rate, which is currently a maximum of 35%, and would pay state income taxes at varying rates. Distributions to us of additional i-units would generally be taxed as a corporate distribution. Because a tax would be imposed upon Kinder Morgan Energy Partners as a corporation, the cash available for distribution to common unitholders would be substantially reduced, which would reduce the values of i-units distributed quarterly to us and our shares distributed quarterly to our shareholders. Treatment of Kinder Morgan Energy Partners as a corporation would cause a substantial reduction in the value of our shares. Current law or Kinder Morgan Energy Partners' business may change so as to cause Kinder Morgan Energy Partners to be treated as a corporation for United States federal income tax purposes or otherwise subject Kinder Morgan Energy Partners to entity-level taxation. Members of Congress are considering substantive changes to the existing United States federal income tax laws that affect certain publicly-traded partnerships. For example, United States federal income tax legislation has been proposed that would eliminate partnership tax treatment for certain publicly-traded partnerships. Although the currently proposed legislation would not appear to affect Kinder Morgan Energy Partners' tax treatment as a partnership, we are unable to predict whether any of these changes, or other proposals, will ultimately be enacted. Any such changes could negatively impact the value of an investment in our shares. In addition, because of widespread state budget deficits and other reasons, several states are evaluating ways to subject partnerships to entity-level taxation through the imposition of state income, franchise or other forms of taxation. For example, Kinder Morgan Energy Partners is now subject to an entity-level tax on the portion of its total revenue that is generated in Texas. Specifically, the Texas margin tax is imposed at a maximum effective rate of 0.7% of Kinder Morgan Energy Partners' total revenue that is apportioned to Texas. This tax reduces, and the imposition of such a tax on Kinder Morgan Energy Partners by any other state will reduce, Kinder Morgan Energy Partners' cash available for distribution to its partners. If any state were to impose a tax upon Kinder Morgan Energy Partners as an entity, the cash available for distribution to its common unitholders would be reduced, which would reduce the values of i-units distributed quarterly to us and our shares distributed quarterly to our shareholders. Kinder Morgan Energy Partners' partnership agreement provides that if a law is enacted that subjects Kinder Morgan Energy Partners to taxation as a corporation or otherwise subjects Kinder Morgan Energy Partners to entity-level taxation for United States federal income tax purposes, the minimum quarterly distribution and the target distribution levels will be adjusted to reflect the impact on Kinder Morgan Energy Partners of that law. As an owner of i-units, we may not receive value equivalent to the common unit value for our i-unit interest in Kinder Morgan Energy Partners if Kinder Morgan Energy Partners is liquidated. As a result, a shareholder may receive less per share in our liquidation than is received by an owner of a common unit in a liquidation of Kinder Morgan Energy Partners. If Kinder Morgan Energy Partners is liquidated and Knight Inc. does not satisfy its obligation to purchase your shares, which is triggered by a liquidation, then the value of your shares will depend on the after-tax amount of the liquidating distribution received by us as the owner of i-units. The terms of the i-units provide that no allocations of income, gain, loss or deduction will be made in respect of the i-units until such time as there is a liquidation of Kinder Morgan Energy Partners. If there is a liquidation of Kinder Morgan Energy Partners, it is intended that we will receive allocations of income and gain in an amount necessary for the capital account attributable to each i-unit to be equal to that of a common unit. As a result, we will likely realize taxable income upon the liquidation of Kinder Morgan Energy Partners. However, there may not be sufficient amounts of income and gain to cause Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of these registration statements. If the only securities being registered on this Form are being offered pursuant to dividend or interest reinvestment plans, please check the following box If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, other than securities offered only in connection with dividend or interest reinvestment plans, check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a registration statement pursuant to General Instruction I.D. or a post-effective amendment thereto that shall become effective upon filing with the Commission pursuant to Rule 462(e) under the Securities Act, check the following box. If this Form is a post-effective amendment to a registration statement filed pursuant to General Instruction I.D. filed to register additional securities or additional classes of securities pursuant to Rule 413(b) under the Securities Act, check the following box. Indicate whether each registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. Kinder Morgan Management, LLC Large Accelerated Filer Kinder Morgan Energy Partners, L.P. Large Accelerated Filer Knight Inc. Non-accelerated Filer The Registrants hereby amend these Registration Statements on such date or dates as may be necessary to delay their effective date until the Registrants shall file a further amendment which specifically states that these Registration Statements shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statements shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents the capital account attributable to each i-unit to be equal to that of a common unit. If they are not equal, we, and therefore our shareholders, will receive less value than would be received by an owner of common units. Further, the tax indemnity provided to us by Knight Inc. only indemnifies us for our tax liabilities to the extent we have not received sufficient cash in the transaction generating the tax liability to pay the associated tax. Prior to any liquidation of Kinder Morgan Energy Partners, we do not expect to receive cash in a taxable transaction. If a liquidation of Kinder Morgan Energy Partners occurs, however, we likely would receive cash which would need to be used at least in part to pay taxes. As a result, our residual value and the value of our shares likely will be less than the value of the common units upon the liquidation of Kinder Morgan Energy Partners. Kinder Morgan Energy Partners may issue additional common or other units and we may issue additional shares, which would dilute your ownership interest. The issuance of additional common or other units by Kinder Morgan Energy Partners or shares by us other than in our quarterly distributions to you may have the following effects: the amount available for distributions on each share may decrease; the relative voting power of each previously outstanding share will be decreased; and the market price of our shares may decline. The market price of our shares on any given day generally is less than the market price of the common units of Kinder Morgan Energy Partners. Since our initial public offering, our shares have generally traded on the New York Stock Exchange at prices at a discount to, but in general proximity to, the prices of common units of Kinder Morgan Energy Partners. Thus, the market price of our shares on any given day generally is less than the market price of the common units of Kinder Morgan Energy Partners. The market price of our shares will depend, as does the market price of the common units of Kinder Morgan Energy Partners, on many factors, including our operation and management of Kinder Morgan Energy Partners, the future performance of Kinder Morgan Energy Partners, conditions in the energy transportation and storage industry, general market conditions, and conditions relating to businesses that are similar to that of Kinder Morgan Energy Partners. Your shares are subject to optional and mandatory purchase provisions which could result in your having to sell your shares at a time or price you do not like and could result in a taxable event to you. If either of the optional purchase rights are exercised by Knight Inc., or if there is a mandatory purchase event, you will be required to sell your shares at a time or price that may be undesirable, and could receive less than you paid for your shares. Any sale of our shares for cash, to Knight Inc. or otherwise, will be a taxable transaction to the owner of the shares sold. Accordingly, a gain or loss will be recognized on the sale equal to the difference between the cash received and the owner's tax basis in the shares sold. For further information regarding the optional and mandatory purchase rights, please read "Description of Our Shares Optional Purchase" and "Description of Our Shares Mandatory Purchase." Please also read "Material Tax Considerations Tax Consequences of Share Ownership." Table of Contents EXPLANATORY NOTE These registration statements contain a prospectus to be used in connection with the offer and sale of Kinder Morgan Management, LLC shares. These registration statements also register: the deemed offer and sale by Kinder Morgan Energy Partners, L.P. of i-units to be acquired by Kinder Morgan Management, LLC with the net proceeds of the offering of its shares, pursuant to Rule 140 under the Securities Act of 1933, as amended; and the obligation of Knight Inc. to purchase all of the outstanding shares of Kinder Morgan Management, LLC not owned by Knight Inc. or its affiliates under specified circumstances pursuant to the terms of an agreement, which is part of the limited liability company agreement of Kinder Morgan Management, LLC, between Knight Inc. and Kinder Morgan Management, LLC, for itself and for the express benefit of the owners of its shares. Table of Contents Our board of directors has the power to change the terms of the shares in ways our board determines, in its sole discretion, are not materially adverse to the owners of our shares. You may not like the changes, and even if you believe the changes are materially adverse to the owners of shares, you may have no recourse to prevent them. As an owner of our shares, you may not like the changes made to the terms of the shares and you may disagree with the board's decision that the changes are not materially adverse to you as a shareholder. Your recourse if you disagree will be limited because our limited liability company agreement gives broad latitude and discretion to the board of directors and eliminates or reduces the fiduciary duties that our board of directors would otherwise owe to you. For further information regarding amendments to the shares, our limited liability company agreement and other agreements, please read "Description of Our Shares Limited Voting Rights." Knight Inc. may be unable to purchase shares upon the occurrence of the mandatory purchase events, resulting in a loss in value of your shares. The satisfaction of the obligation of Knight Inc. to purchase shares following a purchase event is dependent on Knight Inc.'s financial ability to meet its obligations. There is no requirement for Knight Inc. to secure its obligation or comply with financial covenants to ensure its performance of these obligations. If Knight Inc. is unable to meet its obligations upon the occurrence of a mandatory purchase event, you may not receive cash for your shares. A person or group owning 20% or more of the aggregate number of issued and outstanding Kinder Morgan Energy Partners common units and our shares, other than Knight Inc. and its affiliates, may not vote common units or shares; as a result, you are less likely to receive a premium for your shares in a hostile takeover. Any common units and shares owned by a person or group that owns 20% or more of the aggregate number of issued and outstanding common units and shares cannot be voted. This limitation does not apply to Knight Inc. and its affiliates. This provision may: discourage a person or group from attempting to take over control of us or Kinder Morgan Energy Partners; and reduce the prices at which the common units and our shares will trade under certain circumstances. For example, a third party will probably not attempt to remove the general partner of Kinder Morgan Energy Partners and take over our management of Kinder Morgan Energy Partners by making a tender offer for the common units at a price above their trading market price. Owners of our shares have limited voting rights and therefore have little or no opportunity to influence or change our management. Kinder Morgan G.P., Inc. owns all of our shares eligible to vote on the election of our directors and, therefore, is entitled to elect all of the members of our board of directors. For a description of the limited voting rights you will have as an owner of shares, see "Description of Our Shares Limited Voting Rights." Kinder Morgan G.P., Inc. has delegated to us, to the fullest extent permitted under Delaware law and the Kinder Morgan Energy Partners partnership agreement, all of its rights and powers to manage and control the business and affairs of Kinder Morgan Energy Partners, subject to Kinder Morgan G.P., Inc.'s right to approve specified actions. Table of Contents The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to Completion, dated February 11, 2009. PRELIMINARY PROSPECTUS Shares Representing Limited Liability Company Interests We are offering to sell up to shares representing limited liability company interests of Kinder Morgan Management, LLC. Our shares are listed on the New York Stock Exchange under the symbol "KMR." On , 2009, the last reported sale price of our shares on the New York Stock Exchange was $ per share. Investing in the shares involves risks. "Risk Factors" begin on page 4. Table of Contents There is a potential for change of control if Knight Inc. defaults on debt. Knight Inc. owns all of the outstanding capital stock of the general partner of Kinder Morgan Energy Partners. If Knight Inc. defaults on its debt, in exercising their rights as lenders, Knight Inc.'s lenders could acquire control of the general partner of Kinder Morgan Energy Partners or otherwise influence the general partner of Kinder Morgan Energy Partners through control of Knight Inc. Our limited liability company agreement restricts or eliminates a number of the fiduciary duties that would otherwise be owed by our board of directors to our shareholders, and the partnership agreement of Kinder Morgan Energy Partners restricts or eliminates a number of the fiduciary duties that would otherwise be owed by the general partner to the unitholders. Modifications of state law standards of fiduciary duties may significantly limit the ability of our shareholders and the unitholders to successfully challenge the actions of our board of directors and the general partner of Kinder Morgan Energy Partners, respectively, in the event of a breach of their fiduciary duties. These state law standards include the duties of care and loyalty. The duty of loyalty, in the absence of a provision in the limited liability company agreement or the limited partnership agreement to the contrary, would generally prohibit our board of directors or the general partner of Kinder Morgan Energy Partners from taking any action or engaging in any transaction as to which it has a conflict of interest. Our limited liability company agreement and the limited partnership agreement of Kinder Morgan Energy Partners contain provisions that prohibit our shareholders and the limited partners, respectively, from advancing claims that otherwise might raise issues as to compliance with fiduciary duties or applicable law. For example, the limited partnership agreement of Kinder Morgan Energy Partners provides that the general partner of Kinder Morgan Energy Partners may take into account the interests of parties other than Kinder Morgan Energy Partners in resolving conflicts of interest. Further, it provides that in the absence of bad faith by the general partner of Kinder Morgan Energy Partners, the resolution of a conflict by the general partner will not be a breach of any duty. The provisions relating to the general partner of Kinder Morgan Energy Partners apply equally to us as its delegate. Our limited liability company agreement provides that none of our directors or officers will be liable to us or any other person for any acts or omissions if they acted in good faith. If the market price of our shares fluctuates after your purchase pursuant to this offering, you could lose a significant part of your investment. There has been significant volatility in the market price and trading volume of equity securities, which often is unrelated to the financial performance of the companies issuing the securities. The market price of our shares is likely to be similarly volatile, and you may not be able to resell your shares at or above your purchase price due to fluctuations in the market price of our shares, including changes in price caused by factors unrelated to our or Kinder Morgan Energy Partners' operating performance or prospects. Specific factors that may have a significant effect on the market price for our shares include: changes in projections as to Kinder Morgan Energy Partners' level of capital spending; changes in stock market analyst recommendations or earnings estimates regarding our shares, the Kinder Morgan Energy Partners common units, other comparable companies or the energy industry generally; actual or anticipated fluctuations in our or Kinder Morgan Energy Partners' operating results, future prospects or distributions; reaction to our public announcements and those of Kinder Morgan Energy Partners; Table of Contents In July 2008, Mr. Richard D. Kinder and the compensation committee of Kinder Morgan Management's board of directors approved a special contribution through July 2009 of an additional 1% of base pay into the Savings Plan for each eligible employee. Each eligible employee will receive an additional 1% company contribution based on eligible base pay each pay period beginning with the first pay period of August 2008 and continuing through the last pay period of July 2009. The additional 1% contribution does not change or otherwise impact, the annual 4% contribution that eligible employees currently receive. It may be converted to any other Savings Plan investment fund at any time and it will vest according to the same vesting schedule described in the preceding paragraph. Since this additional 1% company contribution is discretionary, Mr. Kinder's and the Kinder Morgan Management compensation committee's approvals will be required annually for each additional contribution. During the first quarter of 2009, excluding our portion of the 1% additional contribution described above, we will not make any additional discretionary contributions to individual accounts for 2008. Additionally, in 2006, an option to make after-tax "Roth" contributions (Roth 401(k) option) to a separate participant account was added to the Savings Plan as an additional benefit to all participants. Unlike traditional 401(k) plans, where participant contributions are made with pre-tax dollars, earnings grow tax-deferred, and the withdrawals are treated as taxable income, Roth 401(k) contributions are made with after-tax dollars, earnings are tax-free, and the withdrawals are tax-free if they occur after both (i) the fifth year of participation in the Roth 401(k) option, and (ii) attainment of age 591/2, death or disability. The employer contribution will still be considered taxable income at the time of withdrawal. Knight Inc. Cash Balance Retirement Plan. Employees of ours and KMGP Services Company, Inc., including our named executive officers, are also eligible to participate in a Cash Balance Retirement Plan. Certain employees continue to accrue benefits through a career-pay formula, "grandfathered" according to age and years of service on December 31, 2000, or collective bargaining arrangements. All other employees accrue benefits through a personal retirement account in the Cash Balance Retirement Plan. Under the plan, we make contributions on behalf of participating employees equal to 3% of eligible compensation every pay period. Interest is credited to the personal retirement accounts at the 30-year U.S. Treasury bond rate, or an approved substitute, in effect each year. Employees become fully vested in the plan after five years, and they may take a lump sum distribution upon termination of employment or retirement. The following table sets forth the estimated actuarial present value of each named executive officer's accumulated pension benefit as of December 31, 2008, under the provisions of the Cash Balance Retirement Plan. With respect to our named executive officers, the benefits were computed using the same assumptions used for financial statement purposes, assuming current remuneration levels without any salary projection, and assuming participation until normal retirement at age sixty-five. These benefits are subject to federal and state income taxes, where applicable, but are not subject to deduction for social security or other offset amounts. Pension Benefits Name Plan Name Current Credited Yrs of Service Present Value of Accumulated Benefit(1) Contributions During 2008 Richard D. Kinder Cash Balance 8 $ $ Kimberly A. Dang Cash Balance 7 39,693 8,285 Steven J. Kean Cash Balance 7 50,479 8,755 Joseph Listengart Cash Balance 8 60,267 9,188 C. Park Shaper Cash Balance Per Share Total Public offering price $ $ Underwriting discount $ $ Proceeds to us before expenses $ $ We have granted the underwriters a 30-day option to purchase up to shares on the same terms and conditions as set forth above if the underwriters sell more than shares in this offering. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The underwriters expect to deliver the shares on or about , 2009. Table of Contents new laws or regulations or new interpretations of existing laws or regulations applicable to our business and operations and those of Kinder Morgan Energy Partners; changes in accounting standards, policies, guidance, interpretations or principles; and adverse conditions in the financial markets or general economic conditions, including those resulting from war, incidents of terrorism and responses to such events. In addition, many of the other risks that are described under the heading "Risk Factors" in the Annual Reports on Form 10-K for the year ended December 31, 2007, of Kinder Morgan Energy Management, LLC and Kinder Morgan Energy Partners and their subsequent Quarterly Reports on Form 10-Q filed during 2008 and any subsequently filed Annual Reports or other Exchange Act reports could also materially and adversely affect the price of our shares. Stock markets have experienced price and volume volatility that has affected the market price of many companies' equity securities. Fluctuations such as those could affect the market price of our shares. The date of this prospectus is , 2009. Table of Contents

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+RISK FACTORS Investing in our common stock involves substantial risks. You should be able to bear a complete loss of your investment. You should carefully consider the following factors and other information in this prospectus before deciding to exercise your subscription rights and purchase our common stock. Risk Factors Relating to the Offering of Subscription Rights The subscription price is substantially above the recent market price of our common stock. The subscription price of $.32 per share is substantially higher than the recent market prices for our common stock. The bid price for our common stock in the market has not been as high as the subscription price since the first quarter of 2007. We do not expect the public market price of our common stock to exceed the subscription price before the subscription rights expire, if ever. If you exercise your subscription rights then you will have committed to buy shares of common stock in the rights offering at a price that is higher than the price at which our shares could be purchased in the market. Moreover, we cannot assure you that you will ever be able to sell shares of common stock that you purchased in the rights offering at a price equal to or greater than the subscription price. Determination of the subscription price was not based on an independent valuation and may not be the true value of the shares. The terms and conditions of the rights offering, including the subscription price, were not based on an independent valuation of Oceanic. The $.32 subscription price was based in part on the subscription price of our last rights offering and the price our independent directors believed NWO would be willing to pay. The independent directors did not attempt to determine the value of our claims asserted in the U.S. Timor Gap Litigation or the probability of success in our lawsuit. The subscription price does not necessarily bear any relationship to our past operations, cash flows, current financial condition, or any other established criteria for value. You should not consider the subscription price as an indication of the value of Oceanic or its common stock or a prediction of the outcome of our current lawsuit. See Determination of Offering Price. You will not be able to revoke your exercise of subscription rights. Once you exercise your subscription rights, you cannot revoke the exercise. Your percentage ownership of Oceanic Exploration Company may be diluted. If you do not exercise all of your basic subscription rights, you may suffer significant dilution of your percentage ownership of our stock relative to stockholders who fully exercise their subscription rights. For example, if you own 597,000 shares of common stock before the rights offering, or approximately 1.0% of our equity and you exercise none of your subscription rights while all other subscription rights are exercised through the basic subscription privilege or over-subscription privilege, then the percentage ownership represented by your 597,000 shares will be reduced to approximately 0.76%. You will suffer immediate and substantial dilution if you exercise the over-subscription privilege. The difference between the offering price per share of common stock and the pro forma net tangible book value per share of our common stock after this offering constitutes the dilution to investors in this offering. Net tangible book value per share is determined by dividing our net tangible book value, which is our total tangible assets less our total liabilities, divided by the number of outstanding shares of our common stock. As of March 31, 2009, we had a negative net tangible book value of ($3,391,260) or ($0.057) per share. After giving effect to the sale of 19,000,000 shares of common stock included in the rights offering, our pro forma net tangible book value at March 31, 2009 would have been $2,608,740 or approximately $.03 per share, representing an immediate dilution of approximately $.29 per share or 90.63%. Stockholders who exercise the over-subscription privilege will suffer dilution on their newly purchased shares which will not be offset by the increase in the net tangible book value of their existing shares. You may not be able to sell your shares of common stock immediately upon expiration of the rights offering. Until certificates are delivered upon expiration of the rights offering, you may not be able to sell the shares of our common stock that you purchase in the rights offering. Certificates representing shares of our Table of Contents common stock that you purchased will be delivered within 15 business days after the [August 21, 2009] expiration of the rights offering, which may be extended up to 30 days. The rights offering may be cancelled and funds returned without interest. If we elect to cancel the rights offering, we will have no obligation with respect to the subscription rights except to return, without interest, any subscription payments. You will not earn interest on any funds delivered to us to exercise the rights. We will not pay you interest on funds delivered to us pursuant to the exercise of rights. The rights offering may not satisfy our need for capital. We intend to raise approximately $6,080,000 by making this rights offering, but no assurance can be given that we will be able to do so. Because there is no established minimum purchase requirement, we may complete the rights offering without having raised the full $6,080,000. If we do not raise the full $6,080,000, our ability to repay the NWO line of credit and continue to pursue the U.S. Timor Gap Litigation may be limited and we may not be able to fund the ongoing operations to the extent contemplated in this prospectus. Other than our line of credit evidenced by a promissory note with NWO, which allows us to borrow up to an additional $3,300,000, subject to certain conditions, we do not have any commitments for raising either debt or equity capital. We cannot assure you that the funds from this rights offering will be sufficient to fund operations and pursue the claims we have made in the U.S. Timor Gap Litigation. Even if all of the $6,080,000 is raised in this rights offering, we will likely need more capital to fund our operations during or after 2009 if we continue pursuing our claims. We are unable to predict when, or if, we will discontinue our lawsuit. Assuming that the lawsuit continues past 2009, we may need additional capital to fund litigation costs. Such additional financing will present additional risks to our stockholders, depending on the price and terms attached to such funding. See Use of Proceeds. Risk Factors Relating to Oceanic Exploration Company We have suffered recurring material net losses. We have suffered recurring material net losses and losses from operations during the most recent interim period and in recent fiscal years. Net losses for the quarters ended March 31, 2009 and 2008 were $(375,717) and $(622,236), respectively. Net losses for the years ended December 31, 2008, 2007 and 2006 were $(2,263,483), $(1,729,132) and $(2,489,509), respectively. Our stockholders equity decreased from a negative ($2,980,409) at December 31, 2008 to a negative $(3,356,126) as of March 31, 2009. As long as we continue to incur significant expenses for the U.S. Timor Gap Litigation, we expect significant losses to continue. Our only significant revenue in fiscal years 2008, 2007 and 2006 was from management services to related parties. We provide management and other services to San Miguel, Cordillera and HIRL. The contracts with each company do not provide for an end date but most do contain a clause requiring 60 days termination notice. Each of these companies is a related party. There is no assurance that the management services agreements will continue in the future. We currently have no oil and gas operations or revenues but have increasing costs charged to exploration expenses, which are primarily legal and professional expenses related to the U.S. Timor Gap Litigation. We have not generated any material revenues from oil and gas operations for the past seven fiscal years and there is no assurance that oil and gas revenue will be generated in the future. We are currently actively pursuing legal claims asserted in the U.S. Timor Gap Litigation. During the three month periods ended March 31, 2009 and 2008 (unaudited), we incurred litigation related expenses of $196,711 and $422,946, respectively. During the years ended December 31, 2008, 2007 and 2006, these expenses were $1,779,648, $1,100,887 and $1,793,515, respectively. We will spend a majority of the net proceeds from the rights offering repaying NWO for prior advances on a line of credit and pursuing these claims. We expect that expenses relating to the claims will continue to be significant until our litigation is resolved. We may be unsuccessful with respect to the U.S. Timor Gap Litigation. No government of East Timor has recognized the concession other than Portugal, which granted the concession to our 99% owned subsidiary, Petrotimor Companhia de Petr leos, SA (Petrotimor) in December 1974 when East Timor was under its Table of Contents administrative control. Regardless of the outcome of the U.S. Timor Gap Litigation, this concession may never be recognized by the government of East Timor. We may be unsuccessful in our pursuit of commercial opportunities in the Timor Gap. On April 22, 2008 the United States District Court for the Southern District of Texas entered a Final Judgment dismissing the case. We have appealed the dismissal to United States Court of Appeals for the Fifth Circuit. Our appeal of the dismissal may not be successful. Even if the case is remanded to the trial court for further proceedings, we may not ultimately succeed in those proceedings. We understand that pursuing this lawsuit to its fullest extent in 2009 could take substantial time by our personnel, and we could incur substantial expense. Additional resources may be required in connection with this litigation. We cannot be certain that our resources in the future will be sufficient to satisfy expenditures we are required to make in our business. If we are unsuccessful in our legal proceedings and do not receive damages for our claims, and do not achieve recognition in East Timor we may have no further interest in the Timor Gap and will have incurred substantial legal and other expenses over a protracted period of time in trying to protect our rights. The U.S. Timor Gap Litigation defendants have substantial resources, and we expect them to continue to contest our claims. While we believe in the merits of our claims, the ultimate outcome cannot be determined at this time. Ultimately, we must obtain a final judgment or settlement of the lawsuit or achieve recognition of our rights by the new government in East Timor in order to recover any benefits in connection with our interests in the Timor Gap. There is no assurance we will be successful in the lawsuit. Even if we are successful in our legal proceedings, the amount of damages that may be awarded cannot be determined at this time. Furthermore, if we are successful in obtaining recognition and entitlement to the benefits of the concession, the ultimate value of the concessions is unknown. We are litigating against parties with substantial resources. The defendants in the U.S. Timor Gap Litigation have far greater resources than we have at the current time. We may not be able to fund the litigation to conclusion or settle the litigation on terms favorable to us; however, we intend to make every effort to do so. We face significant competition. The oil and gas industry is competitive, and we must compete with many long-established companies having far greater resources and operating experience. Furthermore, the demand for financing of oil and gas, mineral exploration and development programs is highly competitive and we compete for such financing with other larger exploration and development companies. There is no independent competition for the management services activities, but each of the related parties to which we provide those services could elect to have their own employees provide those services. Because we are subject to the penny stock rules, the level of trading activity in our stock may be reduced which may make it difficult for investors to sell their shares. Our common stock is penny stock as defined by the Securities Exchange Act of 1934. Broker-dealer practices in connection with transactions in penny stocks are regulated by certain penny stock rules adopted by the Securities and Exchange Commission. Penny stocks, like shares of our common stock, generally are equity securities with a price of less than $5.00, other than securities registered on certain national securities exchanges or quoted on NASDAQ. The penny stock rules require a broker-dealer, prior to a transaction in a penny stock not otherwise exempt from the rules, to deliver a standardized risk disclosure document that provides information about penny stocks and the nature and level of risks in the penny stock market. The broker-dealer also must provide the customer with current bid and offer quotations for the penny stock, the compensation of the broker-dealer and its salesperson in the transaction, and, if the broker-dealer is the sole market maker, the broker-dealer must disclose this fact and the broker-dealer s presumed control over the market, and monthly account statements showing the market value of each penny stock held in the customer s account. In addition, broker-dealers who sell these securities to persons other than established customers and accredited investors must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser s written agreement to the transaction. The inability of institutional investors to trade our common stock and the additional burdens imposed upon stockbrokers by these requirements discourages stockbrokers from effecting transactions in our Table of Contents common stock, which may limit the market liquidity and the ability of investors to trade our common stock. The lack of volume and transactions in our stock may reduce the overall market value of the common stock. Our business in the oil and gas industry is subject to price volatility and foreign risks. Oil and gas exploration activities, especially in foreign areas, are subject to a wide variety of risks that affect not only the concessions themselves but also their salability (whether of partial interests or otherwise) to third parties. The industry is also subject to fluctuations in the price of and the demand for oil and gas. Our foreign operations are subject to risks such as nationalization, jurisdictional disputes, civil unrest, taxation and price and demand fluctuations. Our oil and gas concessions are generally located in territories controlled by foreign governments. As a result, the concessions may be subject to the following risks: Potential expropriation or nationalization of concessions or facilities by foreign governments Jurisdictional disputes between foreign governments concerning areas in which our concessions are located Civil unrest or significant political changes in foreign countries in which we hold concessions Taxation by foreign governments of our income derived within their jurisdiction or other forms of tax combined with uncertainties over the availability in the United States of foreign tax credits for taxes actually paid to foreign governments Application of foreign procedural or substantive laws Fluctuations in the price of and the demand for oil and gas Certain of our properties, including those in Greece, Taiwan and the Timor Gap, are subject to current disputes between foreign governments that have essentially, in addition to our lack of funds, precluded development of those properties. There is no assurance that such disputes will be resolved in a timely manner. At the current time, we do not intend to pay dividends on the common stock. We use all available funds for working capital purposes and have never paid a dividend. We do not anticipate paying dividends at the current time. Any future payment of dividends by us is subject to the discretion of the Board of Directors. We are controlled by our principal stockholder. Our principal stockholder, NWO, currently owns 89.2% of our common stock. If all stockholders fully exercise their subscription rights, the effective percentage ownership of each stockholder will remain unchanged. If none of the other stockholders exercise their rights and NWO purchases all shares of common stock that are available to purchase, then NWO will control approximately 91.8%. In such event, NWO would increase its ownership and all of our current shareholders, except for NWO, would be diluted in percentage ownership of Oceanic. Oceanic s Chairman of the Board of Directors and Chief Executive Officer is also Chairman of the Board of Directors, President and the indirect beneficial owner of a majority of the common stock of Cordillera, which is the major stockholder of NWO. He is also the Chairman of the Board and President of NWO. There are conflicts of interest between us and our affiliates. There have been material transactions between us and our affiliates, some of which cannot be deemed to have been the result of arm s length negotiations. We provide management services to Cordillera and San Miguel and consulting services, including monitoring exploration and production activities on a worldwide basis to identify potential investment opportunities, for HIRL. Our Chairman of the Board of Directors and Chief Executive Officer is affiliated with each of these corporations. In addition, he receives officers fees of $5,000 per month for his services as Chairman of the Board of Directors and Chief Executive Officer. He is President and a director of NWO and Chairman of the Board of Directors, President and an indirect beneficial owner of a majority of the common stock of Cordillera, a related party, and a principal source of our current management revenue. Karsten Blue, son of our Chairman of the Board of Directors and Chief Executive Officer, performs services for us with respect to the Timor Gap matters on a monthly basis for which we pay his employer, General Atomics, $6,500 per month. Karsten Blue provided and will continue to coordinate various activities relating to Timor Gap matters. Table of Contents Effective June 30, 2007, we entered into a Services Agreement with General Atomics (GA), a company controlled by Oceanic s Chairman of the Board of Directors and Chief Executive Officer. This agreement specifies that Oceanic will pay GA for the services of Stephen M. Duncan to serve as President of Oceanic at a fixed rate of $7,500 per month. The agreement has no contractual termination date, but can be terminated with 30 days notice by either party. We also have a $4,000,000 line of credit evidenced by a promissory note with NWO, our principal stockholder, established on February 28, 2008. NWO has agreed to increase its line of credit to Oceanic to $6,000,000 if any of the following occur: (i) Oceanic, by unanimous action of its Board of Directors, determines not to conduct a rights offering or (ii) Oceanic has fully drawn on the existing line of credit and Oceanic certifies that it will not have time to complete the rights offering before it exhausts its current assets needed to continue prosecution of the U.S. Timor Gap Litigation. The terms were not negotiated at arm s length. We lease our office building in Englewood, Colorado from a company indirectly owned and controlled by our Chairman of the Board of Directors and Chief Executive Officer. See Certain Relationships and Related Transactions for further information about these conflicts.

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+RISK FACTORS An investment in our common stock involves a high degree of risk. You should carefully consider the risks described below and the other information contained in this prospectus before deciding to invest in our common stock, including our consolidated and other financial statements and related notes, and the financial statements of our acquired subsidiaries, included elsewhere in this prospectus, before you decide to purchase our common stock. If any of these risks actually occurs, our business, prospects, financial condition or results of operations could be materially and adversely affected, the trading price and value of our common stock could decline and you could lose all or part of your investment. Risks Related to Our Business Our profit margins on sales of our solar water heaters have been declining. Gross profit margin for the three months ended March 31, 2009 decreased by approximately 10% from the corresponding period in 2008. This was primarily due to a decrease in sales of low-margin products such as household water heaters and the relatively higher cost of key raw materials such as stainless steel. We increased stockpiles when the stainless steel price was relatively high, which resulted in a higher production cost and lower profit margins. We expect the gross profit for lower margin products, such as household water heaters, to decrease as a result of increasingly intensive competition in the market, while the gross profit for higher margin products, such as large-scale projects and equipments to increase. Competition in the solar water heater industry in rural areas has recently intensified, causing us to lower our prices and resulting in lower net revenues. We manufacture and market solar hot water heaters and other products. According to China Solar Water Heater Market Investment Analysis and Forecast Report, there were more than 5,000 solar water heater companies scattered around China by the end of 2008. Many of our competitors are better capitalized and more experienced, and have better customer relationships than our firm. While most solar hot water manufacturers focus on the urban markets, we focus on the rural markets. However, competition in the solar water heater industry in rural areas has recently intensified and we have to lower our prices, which has resulted in lower net revenues. We expect this trend to continue in the immediate future. We rely on our sales agents to distribute our solar water heater products and to expand our business we must attract new sales agents; we could lose a substantial portion of our sales if we are not able to effectively monitor the activities of our sales agents. We believe that our success relies, to a large degree, on our distribution network. China is a geographically vast country and it is critical that we strengthen our market shares in a number of different regions. Presently, we sell our products primarily in the rural areas of the north-east part of the PRC, including Hebei, Beijing, Tianjin, Heilongjiang, and Liaoning. In order to expand our business into others regions, we will need to increase our distribution network by using more sales agents, distributors, wholesalers and retailers who will distribute our products. Since our competitors may offer better compensation to distributors and sales agents, we may not be able to attract sufficient distributors and sales agents as necessary to expand our distribution network. In addition, even if the distribution network can be enlarged as planned, we may not be able to operate it efficiently or manage it effectively, given our limited internal resources, all of which could have a material adverse effect on our financial condition and results of operations. We may face challenges in managing our continuous growth. Revenue, net for the three months ended March 31, 2009 were $6,195,691 as compared to $8,300,076 for the same period in the prior year, a decrease of $2,104,385, or 25.35%. The decrease in sales was primarily attributable to a weakening economy. Sales for industrial enterprises in China are usually slow for the first quarter due to the long holiday season around Chinese Lunar New Year. We expect net revenues to increase during the rest of the year with the completion of pending projects in the first quarter and collection of the accounts receivable corresponding to these projects. If our business and markets continue to grow and develop, it will be necessary for us to finance and manage our expansion in an orderly fashion. In addition, we may face challenges in managing the expanding product offerings and in integrating any acquired businesses with our own. This will increase demands on our existing management, workforce and facilities. TABLE OF CONTENTS Failure to effectively deal with these increased demands could interrupt or adversely affect our operations and cause production backlogs, longer product development time frames, and administrative inefficiencies. The protection of intellectual property rights in the PRC is not as effective as in the United States or other countries. Our trademarked brands have gained recognition in the northeast part of the PRC. The protection of intellectual property rights in the PRC, however, is not as effective or enforced to the same degree as in the United States or other countries. The unauthorized use of our brands could enable other manufacturers to take unfair advantage of our brand name, which could harm our business and competitive position. We do not have any long-term supply contracts with our suppliers of raw materials; any significant fluctuation in the price of raw materials may have a material adverse effect on our manufacturing costs. Stainless steel and glass tubing are two major raw materials that we use to manufacture our solar water heaters. The prices of such raw materials are subject to market conditions. We do not have long-term contracts or arrangements with our suppliers. While these raw materials are generally available and we have not experienced any raw material shortages in the past, we cannot assure you that prices will not rise due to market volatility. An increase in component or raw material costs could adversely affect our product prices, which could in turn have a material adverse effect on our financial condition and results of operations. We have to outsource our production to third party manufacturers during the peak sales season due to our limited manufacturing capacity. Under original equipment manufacturer ( OEM ) arrangements, we contract with other manufacturers to produce our products and authorize them to use our brand names or trademarks on these products. We cannot assure you that we will continue to find qualified manufacturers on acceptable terms in the areas where our customers are located. In addition, with respect to those outsourced products, we cannot assure you that the product quality will be fully under our control. Such OEM arrangement has a material impact on our production and business. We may engage in future acquisitions that could dilute the ownership interests of our stockholders, cause us to incur debt and assume contingent liabilities. On March 31, 2008, Deli Solar (Beijing) completed the acquisition of 100% of the outstanding equity interests in SZPSP from its three shareholders for an aggregate purchase price of RMB28,800,000 (approximately $4.0 million) in cash, 1,419,729 shares of our common stock, and five year warrants to purchase 141,973 shares of common stock at an exercise price of $2.50 per share (subject to adjustment). SZPSP was principally engaged in the manufacture of solar hot water systems for commercial use. Its customers included factories, hospitals, schools and hotels. We agreed that if our common stock price is lower than the share price ($2) on the first anniversary date (March 31, 2009) of the closing, we will pay the difference. On July 1, 2007 Deli Solar (Beijing) purchased 51% of the equity in Tianjin Huaneng for a purchase price of approximately $1,689,741. In addition to the purchase price we paid a finder s fee of approximately $769,418. Deli Solar (Beijing) assumed 51% of the liabilities of Tianjin Huaneng and contributed RMB20,000,000 (approximately $2,613,400) as working capital to the acquired company. Deli Solar (Beijing) also agreed to employ the 550 current Tianjin Huaneng employees pursuant to new three year employment contracts. On October 27, 2008, Deli Solar (Beijing) purchased approximately 30% of the outstanding equity interest of Tianjin Huaneng from the minority shareholders of Tianjin Huaneng. Following this transaction, the Company increased the registered capital of Tianjin Huaneng from RMB5.94 million to RMB21.68 million by contributing an additional RMB15,740,000 ($2,295,531). As a result, the Company s equity interest in Tianjin Huaneng increased to approximately 92%. TABLE OF CONTENTS As part of our growth strategy, we review acquisition and strategic investment prospects that we believe would complement our current product offerings, increase our market coverage or enhance our technical capabilities, or otherwise offer growth opportunities. From time to time we anticipate investments in new businesses and we expect to make investments in, and to acquire, businesses, products, or technologies in the future. In the event of any future acquisitions, we may: issue equity securities which would dilute current stockholders percentage ownership; incur substantial debt; assume contingent liabilities; or expend significant cash. These actions could harm our financial condition, operating results or the market price of our common stock. Although we believe that the acquisitions bring us benefits in terms of increased sales and earnings, there may be a lag between the time when the expenses associated with an acquisition are incurred and the time when we recognize such benefits. Acquisitions and investment activities also present numerous risks, including: difficulties in the assimilation of acquired operations, technologies and/or products; unanticipated costs associated with the acquisition or investment transaction; the diversion of management s attention from other business concerns; adverse effects on existing business relationships with suppliers and customers; risks associated with entering markets in which we have no or limited previous experience; potential loss of key employees of acquired organizations; and substantial charges for the amortization of certain purchased intangible assets, deferred stock compensation or similar items. We cannot ensure that we will be able to successfully integrate any businesses, products, technologies, or personnel that we have acquired or might acquire in the future, and our failure to do so could harm our business, operating results and financial condition. We may need additional capital to fund our future operations and, if it is not available when needed, we may need to reduce our planned development and marketing efforts, which may reduce our net revenues. We believe that our existing working capital and cash available from operations will enable us to meet our working capital requirements for at least the next 12 months. However, if our future operations cannot generate sufficient cash, or if the existing cash is used for acquisitions or other currently unanticipated uses, we may need additional capital. However, under our private placements completed on June 13, 2007 and in February 25, 2008, respectively, we agreed to be subject to certain restrictions in connection with future financings. Specifically, we cannot, prior to June 13, 2010, issue any convertible debt or any shares of convertible preferred stock, nor have any debt outstanding in an amount greater than twice EBITDA from continuing operations for the prior four quarters. The preferred stock investors in the private placement also have right of first refusal with respect to any subsequent financing. Those restrictive covenants may inhibit our ability to raise additional funding. On the other hand, the development and marketing of new products, the expansion of distribution channels and the resulting increased need for personnel require significant commitments of capital resources. In addition, if the markets for our products develop more slowly than we anticipated, or if we fail to establish significant market share and achieve sufficient net revenues, we may continue to require significant amounts of capital. As a result, additional capital may be needed for future operations. To the extent that we raise additional capital through equity financing (such as through the sale of convertible debt securities), existing stockholders may suffer from potential dilution in their respective equity ownership. If additional funds are raised through the issuance of debt securities, such securities may provide the holders certain rights, preferences, and privileges senior to those of common stockholders, and the terms of such debt could impose restrictions on our operations. We cannot assure you that additional capital, if required, will be available on acceptable terms, or at all. If we are unable to obtain sufficient amounts of TABLE OF CONTENTS additional capital, we may be required to reduce the scope of our planned product development and marketing efforts, which could harm our business, financial condition and operating results. The relative lack of public company experience of our management team may put us at a competitive disadvantage. We have had a material weakness in our system of internal controls. As a result, current and potential stockholders could lose confidence in our financial reporting, which would harm our business and the trading price of our stock. Our management team lacks experience in working in a public company, which could impair our ability to comply with legal and regulatory requirements such as those imposed by the Sarbanes-Oxley Act of 2002. In light of the extensive legal, regulatory compliance and reporting obligations required under the U.S. securities laws, our senior management may not be able to implement programs and policies adequate to meet their obligations in a timely manner. Our failure to comply with all applicable requirements could lead to the imposition of fines and penalties and distract our management from attending to the growth of our business. Moreover, rules adopted by the SEC pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 require annual assessment of our internal control over financial reporting, and attestation of this assessment by our company's independent registered public accountants. The SEC extended the compliance dates for non-accelerated filers, like us. Accordingly, the annual assessment of our internal controls requirement first applied to our annual report for the 2007 fiscal year and the attestation requirement of management's assessment by our independent registered public accountants will first apply to our annual report for the 2009 fiscal year. The standards that had to be met for management to assess the internal control over financial reporting as effective are new and complex, and require significant documentation, testing and possible remediation to meet the detailed standards. In addition, our efforts to comply with Section 404 may also have diverted management s time and resources from executing our business plan. If management identifies one or more material weaknesses, or our external auditors are unable to attest that our management s report is fairly stated or to express an opinion on the effectiveness of our internal controls, this could result in a loss of investor confidence in our financial reports, have an adverse effect on our stock price and/or subject us to sanctions or investigation by regulatory authorities. Effective internal controls are necessary for us to provide reliable financial reports. If we cannot provide reliable financial reports, our business reputation and operating results could be harmed. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock. In view of the material weakness discovered in 2008 and described in our 10-K for the year ended December 31, 2008 and the need for the restatement of our audited financial statements for such year, management continues to believe that the Company's internal controls over financial reporting are not effective. We do not have key man insurance on our President and CEO, Mr. Du, on whom we rely for the management of our business. We depend, to a large extent, on the abilities and participation of our current management team, but have a particular reliance upon Mr. Deli Du, our CEO. The loss of the services of Mr. Du, for any reason, may have a material adverse effect on our business and prospects. We cannot assure you that we will be able to find a suitable replacement for Mr. Du. We do not carry key man life insurance for any of our key personnel. We may not be able to hire and retain qualified personnel to support our growth and if we are unable to retain or hire these personnel in the future, our ability to improve our products and implement our business objectives could be adversely affected. Competition for senior management and senior technology personnel in the PRC is intense, the pool of qualified candidates in the PRC is very limited, and we have had and may in the future have difficulty in attracting and retaining the services of senior executives. This could harm our future growth and financial condition. TABLE OF CONTENTS We do not presently maintain product liability and other types of insurance. We currently do not have theft, product liability or other similar insurance, nor do we have property insurance covering our plants, manufacturing equipment and office buildings. Although product liability lawsuits in the PRC are rare and we have never experienced significant failure of our products, we cannot rule out the possibility of product liability in the event of any failure or defect of our products and the lack of product liability insurance may expose us to significant risks in this respect. The potential losses or liabilities for product liability, theft, damage to our property, or otherwise, could be substantial, and such loss or liability may have a material adverse effect on our business, financial condition and prospects. Rapid technological changes in our industry could render our products non-competitive or obsolete and consequently affect our ability to generate revenues. The solar hot water industry is subject to rapid technological changes. Our future success will depend on our ability to respond to rapidly changing technologies and to improve our product quality. The failure to adapt to those changes could harm our business. Moreover, we plan to market our products into urban areas of China and this requires us to design and manufacture more innovative products to better suit customers needs in urban areas. If we are slow to develop new products and technologies that are attractive to people in these urban areas, we may not be successful in capturing a significant share of this market. For example, most of our current products rely on a tubular structure while urban customers prefer a flat plate collector for aesthetic purposes. If we fail to keep up with rapid technological changes to remain competitive in our rapidly evolving industry, our future marketing and expansion may be adversely affected. Most of our warranty services are performed by our independent sales agents and distributors whose deposit may not cover total warranty claims. We provide a three-year standard warranty to our end users for all of the products we manufacture. Under this standard warranty program, we provide free repair and exchange of component parts in the first year following the purchase, and we charge labor costs for repair and maintenance but provide free exchange of component parts in the second and third years following the purchase. Thereafter, end users are required to pay for any repair and maintenance services, as well as exchange of component parts. Most of our warranty services are performed by our independent sales agents and distributors in return for a 1 2% discount of the purchase price they pay for our products. According to the standard terms of our agreement with sales agents, we allow our sales agents and distributors to return any defective product for exchange. Our financial statements do not provide for a reserve for product warranties and these expenses have not been significant to date. Although we have not experienced any significant product returns or repairs, we cannot assure you that these sales agents and distributors will perform the warranty services when required, and if they fail to do so, we cannot assure you that the agents' deposits will be sufficient to cover the costs associated with the warranty services to be performed on the products sold by such sales agents and distributors. We lease some of the real property on which our business center, exhibition center and other facilities are located, and there is no guarantee that our lease will be renewed. All land in the PRC is owned by the government and cannot be sold to any individual or entity. Instead, the PRC government grants landholders a land use right . Our business center in Bazhou City and our exhibition center in Beijing are located on leased land as are our manufacturing facilities. There is no assurance that we may renew the leases on acceptable terms. The failure to obtain the renewal of the leases on reasonable terms could cause us to incur extra expenses and costs for alternative land and for the reconstruction of our buildings. A government certificate has yet to be issued to us to confirm our land use right for a plot of land on which we plan to expand our Bazhou operations. On March 17, 2006, Bazhou Deli Solar entered into an agreement with the local government to acquire land use rights for a plot of land of 61,530 square meters at the price of approximately $919,858. This piece of land is close to the present Bazhou factory and will be used to enlarge the present manufacturing base at Bazhou City. The land use right has been approved by the local government after payment of approximately $919,858. However, an official certificate evidencing the land lease has not yet been delivered from the government to us. Failure to obtain the certificate could result in the local authorities refusing us the use of the land. TABLE OF CONTENTS Effect of the Issuance of the Preferred Stock and Warrants in June 2007 and Common Stock in February 2008 The resale in the public market of the shares underlying the Preferred Stock and Warrants acquired in the June 2007 financing, the resale in the public market of the common stock acquired in the February 2008 private placement and the resale of the common stock covered by this prospectus may have an adverse impact on the market value of our common stock. We have registered for resale a total of 11,564,683 shares of our common stock, and believe that recent sales in the public and private markets of these shares of common stock have had a significant adverse effect on the market price of our common stock. We are further registering, pursuant to a registration statement of which this prospectus forms a part, another 1,000,000 shares of common stock for resale. On December 31, 2008, the closing price of our common stock as reported on the OTCBB was $1.05, and on June 26, 2009, the closing price of our common stock on the OTCBB was $0.35. Further sales of these securities in the public and private markets could continue to materially and adversely affect the market price of our common stock. We believe that sales by these investors have caused the market price of our shares to fall significantly over the last few months. The resale of the additional shares of common stock contemplated hereunder may adversely affect the trading market for our common stock and adversely affect the prevailing market price of our common stock. The Series A Preferred Stock and the Warrants have anti-dilution protection which may have an adverse impact on the market value of our common stock and out ability to raise additional financing. The holders of the Series A Preferred Stock have full ratchet anti dilution protection and the holders of the class A and class B warrants have weighted average anti-dilution protection. This may prove a hindrance to our efforts to raise future equity and debt funding, and the exercise of such rights will dilute the percentage ownership interest of our stockholders and will dilute the value of their stock. The Series A Preferred Stock and Warrants may adversely affect our financial and operational flexibility. The terms of the June 13, 2007 financing imposed restrictions on us that may affect our ability to successfully operate our business. The transaction documents contain a number of covenants that may restrict our ability to operate, including, among other things, covenants that restrict our ability: to incur additional indebtedness; to pay dividends on our capital stock; to redeem or repurchase our common stock or any class or series of capital stock that is junior or on a parity with the Series A Preferred Stock; to enter into any transaction that has any reset feature that could result in additional shares being issued. to enter into any subsequent financing. Risk Related to Our Industry A drop in the retail price of conventional energy or non-solar alternative energy or any improvement to rural households electricity supply system in the PRC may have a materially adverse effect on our business. A customer's decision to purchase our solar power products is primarily driven by the poor electricity supply system in the rural areas of the PRC, as well as the energy savings from our solar power products. An improvement in the power supply infrastructure in the rural areas of the PRC could adversely affect the demand for our products. In addition, fluctuations in economic and market conditions that impact the viability of conventional and non-solar alternative energy sources, such as decreases in the prices of oil and other fossil fuels could cause the demand for our solar power heaters to decline. Although we believe that current retail TABLE OF CONTENTS energy prices support a reasonable return on investment for our products, there can be no assurance that future retail pricing of conventional energy and non-solar alternative energy will remain at such levels. Our business will be adversely affected if any of the foregoing occurs. Existing regulations and changes to existing regulations may present technical, regulatory and economic barriers to the purchase and use of solar power products, which may significantly reduce demand for our products. Our solar power products and their installation are subject to oversight and regulation in accordance with national and local ordinances relating to building codes, safety, environmental protection, utility interconnection, metering and related matters. We are responsible for knowing the requirements of individual cities and must design equipment to comply with varying standards. Any new government regulations or utility policies that relate to our solar power products may result in significant additional expenses to us, our resellers and their customers and, as a result, could cause a significant reduction in demand for our solar power products. If solar power technology is not suitable for widespread adoption or sufficient demand for solar power products does not develop or takes longer to develop than we anticipate, our sales would not significantly increase and we would be unable to sustain profitability. The market for solar power products is emerging and rapidly evolving, and its future success is uncertain. If solar power proves to be unsuitable for widespread commercial or residential use or if demand for solar power products fails to develop sufficiently, we would be unable to generate enough revenues to sustain profitability. In addition, demand for solar power products in the new markets that we target may not develop at all or may develop more slowly than we anticipate. Many factors will influence the widespread adoption of solar power technology and demand for solar power products, including: cost-effectiveness of solar power technologies as compared with conventional and non-solar alternative energy technologies; performance and reliability of solar power products as compared with conventional and non-solar alternative energy technologies; and capital expenditures by customers that tend to decrease if the PRC or global economy slows down. Risks Related to Doing Business in the PRC Adverse changes in PRC economic and political policies could have a material adverse effect on the overall economic growth of China, which could reduce the demand for electricity and materially and adversely affect our business. Our operating businesses are based in China and all of our power sales are made in China. As such, our business, financial condition, results of operations and prospects are affected significantly by economic, political and legal developments in China. The PRC economy differs from the economies of most developed countries in many aspects, including: the level of government involvement; the level of development; the growth rate; the level and control of capital investment; the control of foreign exchange; and the allocation of resources. While the Chinese economy has grown significantly in the past two decades, the growth has been uneven geographically, among various sectors of the economy and during different periods. We cannot assure you that the Chinese economy will continue to grow or to do so at the pace that has prevailed in recent years, or that if there is growth, such growth will be steady and uniform. In addition, if there is a slowdown, such slowdown could have a negative effect on our business. For example, the Chinese economy experienced high TABLE OF CONTENTS inflation in the second half of 2007 and the first half of 2008. China s consumer price index increased by 7.9% during the six months ended June 30, 2008 as compared to the same period in 2007. To combat inflation and prevent the economy from overheating, the PRC government adopted a number of tightening macroeconomic measures and monetary policies. Due in part to the impact of the global crisis in financial services and credit markets and other factors, the growth rate of China s gross domestic product decreased to 6.1% in the first quarter of 2009, down from 11.9% in the second quarter of 2007. As a result, beginning in September 2008, among other measures, the PRC government began to loosen macroeconomic measures and monetary policies, including reducing interest rates and decreasing the statutory reserve rates for banks. In addition, in November 2008 the PRC government announced an economic stimulus package in the amount of $586 billion. It is uncertain whether the various macroeconomic measures, monetary policies and economic stimulus packages adopted by the PRC government will be effective in restoring or sustaining the fast growth rate of the Chinese economy. In addition, such measures, even if they benefit the overall Chinese economy in the long-term, may have a negative effect on us. For example, our financial condition and results of operations may be materially and adversely affected by government control over capital investments. Although the Chinese economy has been transitioning from a planned economy to a more market oriented economy, a substantial portion of the productive assets in China is still owned by the PRC government. The continued control of these assets and other aspects of the national economy by the PRC government could materially and adversely affect our business. The PRC government also exercises significant control over Chinese economic growth through allocating resources, controlling payment of foreign currency denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. Any adverse change in the economic conditions or government policies in China could have a material adverse effect on the overall economic growth and the level of investments and expenditures in China, which in turn could lead to a reduction in demand for electricity and consequently have a material adverse effect on our businesses. Interpretation of PRC laws and regulations involves uncertainty. We are incorporated in Cayman Islands and are subject to laws and regulations applicable to foreign investments in China and, in particular, laws applicable to wholly foreign-owned companies. All of our operating businesses are located within China and are governed by PRC laws and regulations. The PRC legal system is based on written statutes, and prior court decisions can only be used as a reference. Since 1979, the PRC government has promulgated laws and regulations in relation to economic matters such as foreign investment, corporate organization and governance, commerce, taxation and trade. However, due to the fact that these laws and regulations have not been fully developed, and because of the limited volume of published cases and the non-binding nature of prior court decisions, interpretations of PRC laws and regulations are not always uniform and involves a relatively high degree of uncertainty. Laws may be changed without being immediately published or may be amended with retroactive effect. Depending on the government agency or how an application or case is presented to such agency, we may receive less favorable interpretations of laws and regulations than certain of our competitors. In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention. The new Antimonopoly Law may subject our future acquisitions to increased scrutiny, which could affect our ability to consummate acquisitions on terms favorable to us or at all. On August 8, 2006, six PRC government authorities, including the PRC Ministry of Commerce, the State Administration for Industry and Commerce, and the China Securities Regulatory Commission, promulgated a rule entitled Provisions regarding Mergers and Acquisitions of Domestic Enterprises by Foreign Investors , or the New M&A Rule, which became effective on September 8, 2006. The New M&A Rule, among other things, requires that certain acquisitions of Chinese domestic enterprises by foreign investors be subject to anti-trust scrutiny by the Ministry of Commerce and the State Administration for Industry and Commerce. The Antimonopoly Law of China, or the AL, was adopted by the Standing Committee of the National People s Congress on August 30, 2007 and became effective on August 1, 2008. The AL was enacted in part to guard against and cease monopolistic activities, and to safeguard and promote orderly market competition. In accordance with the AL, monopolistic acts shall include monopolistic agreements among business operators, abuse of dominant market positions by business operators and concentration of business operators that eliminates or restricts competition or might be eliminating or restricting competition. TABLE OF CONTENTS On August 3, 2008, the State Council promulgated the Regulations on the Thresholds for Reporting of Concentration of Business Operators, or the Reporting Threshold Regulations, which provide specific thresholds for reporting of concentration of business operators. See Regulation. We are advised by our PRC counsel, Global Law Office, that the reporting thresholds and review procedures stipulated in the AL and the Reporting Threshold Regulations supersede those provided in the New M&A Rule. Under the AL and the Reporting Threshold Regulations, the parties to an acquisition must report to the Ministry of Commerce in advance if in the preceding accounting year the turnover in the aggregate achieved by all the parties to the transaction exceeds RMB10.0 billion worldwide or RMB2.0 billion within China, and the turnover achieved by at least two of them respectively exceeds RMB400.0 million within China. However, the Ministry of Commerce has the right to initiate investigation of a transaction not reaching the above-mentioned reporting thresholds if the Ministry of Commerce has evidence that the transaction has or may have the effect of excluding or restricting competition. The anti-trust scrutiny procedures and requirements set forth in the AL and the Reporting Threshold Regulations grant the government extensive authority of evaluation and control over the terms of acquisitions in China by foreign investors, and their implementation involves significant uncertainties and risks. To the extent our future acquisitions meet the threshold requirements set forth in the AL and the Reporting Threshold Regulations, or are deemed by the Ministry of Commerce to meet the thresholds, we will be subject to anti-monopoly review. The consummation of our future acquisitions could therefore be much more time-consuming and complex, and any required approval processes, including obtaining approval from the Ministry of Commerce, may delay or prevent the consummation of such acquisitions, and prevent us from attaining our business objectives. A newly enacted PRC tax law could increase the enterprise income tax rate applicable to our operating businesses in China, which could have a material adverse effect on our results of operations. On March 16, 2007, the new PRC Enterprise Income Tax law, or EIT Law, was enacted, which became effective on January 1, 2008 and replaced the previous two separate tax legal regimes for foreign invested enterprises, or FIEs, and Chinese domestic companies. The EIT Law adopts a uniform tax rate of 25% for all enterprises, including FIEs, and revokes many of the previous tax exemption, reduction and preferential treatments which were applicable to FIEs. However, any enterprises that were established before the promulgation of the EIT Law that are entitled to preferential tax treatments for a fixed period will continue to be entitled to such preferential tax treatments until the expiration of such period. If the fixed period has not commenced because of losses, it shall be deemed to commence on January 1, 2008. In addition, certain qualified high-technology enterprises may still benefit from a preferential tax rate of 15% under the EIT Law if they meet the criteria of high and new technology enterprises strongly supported by the State . As a result, the applicable tax rate to certain of our existing PRC operating businesses have increased from 15% to the unified tax rate of 25% under the EIT Law. Moreover, the EIT Law provides that a withholding income tax rate of 20% will be applicable to dividends payable to foreign investors that are non-resident enterprises to the extent such dividends have their source within China unless the jurisdiction of such foreign investor has a tax treaty with China that provides a different withholding arrangement. The implementing regulations to the EIT Law subsequently reduced this withholding income tax rate from 20% to 10%. See Regulation Tax Law Enterprise Income Tax Law. We may be deemed a PRC resident enterprise under the EIT Law and be subject to PRC taxation on our worldwide income. The EIT Law also provides that enterprises established outside of China whose de facto management bodies are located in China are considered resident enterprises and are generally subject to the uniform 25% enterprise income tax rate as to their worldwide income. Under the implementation regulations to the EIT Law issued by the State Council, de facto management body is defined as a body that has material and overall management and control over the manufacturing and business operations, personnel and human resources, finances and treasury, and acquisition and disposition of properties and other assets of an enterprise. It remains unclear how the PRC tax authorities will interpret this term. A substantial number of our management personnel are located in the PRC, and all of our revenues arise from our operations in China. TABLE OF CONTENTS However, we do recognize some interest income and other gains from our financing activities outside China. If the PRC tax authorities determine that we are a PRC resident enterprise, we will be subject to PRC tax on our worldwide income at the 25% uniform tax rate, which may have a material adverse effect on our financial condition and results of operations. Notwithstanding the foregoing provision, the new EIT Law also provides that, if a resident enterprise already invests in another resident enterprise, the dividends received by the investing resident enterprise from the invested resident enterprise are exempt from income tax, subject to certain qualifications. Therefore, if we are classified as a resident enterprise, the dividends received from our PRC subsidiaries and investee company may be exempt from income tax. However, due to the short history of the EIT Law, it is unclear as to (i) the detailed qualification requirements for such exemption and (ii) whether dividend payments by our PRC subsidiaries and investee company to us will meet such qualification requirements, even if we are considered a PRC resident enterprise for tax purposes. Interest and dividends payable by us to our foreign investors and gain on the sale of our ADSs or ordinary shares may become subject to withholding taxes under PRC tax laws, which may materially and adversely affect your investment in our ordinary shares or ADSs. Under the EIT Law and implementation regulations issued by the State Council, PRC withholding tax at the rate of 10% is applicable to interest and dividends payable to investors that are non-resident enterprises, which do not have an establishment or place of business in China, or which have such establishment or place of business but the relevant income is not effectively connected with the establishment or place of business, to the extent such interest or dividends have their sources within China. Similarly, any gain realized on the transfer of ADSs or shares by such investors is also subject to 10% PRC withholding tax if such gain is regarded as income derived from sources within China. If we are considered a PRC resident enterprise, it is unclear whether the interest or dividends we pay with respect to our ordinary shares or ADSs, or the gain our non-PRC shareholders or ADS holders may realize from the transfer of our ordinary shares or ADSs, would be treated as income derived from sources within China and be subject to PRC tax. If we are required under the EIT Law to withhold PRC income tax on interest or dividends payable to our non-PRC shareholders that are non-resident enterprises, or if you are required to pay PRC income tax on the transfer of our ordinary shares or ADSs, the value of your investment in our ordinary shares or ADSs may be materially adversely affected. We rely principally on dividends and other distributions on equity paid by our operating businesses in China, and limitations on their ability to pay dividends to us could have a material adverse effect on our business and results of operations. We are a holding company and we rely principally on dividends and other distributions on equity paid by our operating businesses in China for our cash and financing requirements, including the funds necessary to pay dividends and other cash distributions to our shareholders, service any debt we may incur and pay our operating expenses. If our operating businesses incur debt on their own behalf in the future, the instruments governing the debt may restrict their ability to pay dividends or make other distributions to us. As entities established in China, our operating businesses are subject to certain limitations with respect to dividend payments. PRC regulations currently permit payment of dividends only out of accumulated profits as determined in accordance with accounting standards and regulations in China. For each of our operating businesses that is a Sino-foreign joint venture enterprise, it may not distribute its after-tax profits to us if it has not already made contributions to its reserve fund, enterprise development fund and employee bonus and welfare fund at percentages that are decided by its board of directors. For each of our operating businesses that is a wholly foreign owned enterprise, it may not distribute its after-tax profits to us if it has not already made contributions to its employee bonus and welfare fund at a percentage that is decided by its board of directors and to its reserve fund at a rate of no less than 10% of its net profit. A wholly foreign owned enterprise is required to continue making contributions to its reserve fund until such fund reaches 50% of its registered capital. These reserve funds may not be distributed as cash dividends. The total amount of our restricted net assets was RMB1,921.7 million ($272.4 million) as of December 31, 2008. In addition, if our operating businesses in China incur further debt on their own behalf in the future, the instruments governing the debt may restrict their ability to pay dividends or make other distributions to us. Limitations on the ability of our operating businesses in China to pay dividends to us could adversely limit our ability to grow, make TABLE OF CONTENTS investments or acquisitions that could be beneficial to our businesses, pay dividends, or otherwise fund and conduct our business. Accordingly, if for any of the above or other reasons, we do not receive dividends from our operating businesses in China, our liquidity, financial condition and ability to make dividend distributions to our shareholders will be materially and adversely affected. Fluctuations in the value of RMB will affect the amount of our non-RMB debt service in RMB terms and affect the value of, and dividends payable on, our ADSs in foreign currency terms. The value of RMB depends, to a large extent, on China s domestic and international economic, financial and political developments and government policies, as well as the currency s supply and demand in the local and international markets. For over 10 years from 1994, the conversion of RMB into foreign currencies, including the U.S. dollar, was based on exchange rates set and published daily by People s Bank of China in light of the previous day s inter-bank foreign exchange market rates in China and the then current exchange rates on the global financial markets. The official exchange rate for the conversion of RMB into the U.S. dollar was largely stable until July 2005. On July 21, 2005, People s Bank of China revalued RMB by reference to a basket of foreign currencies, including the U.S. dollar. As a result, the value of RMB appreciated by 2% on that day. Since then, China central bank has allowed the official RMB exchange rate to float against a basket of foreign currencies, and the RMB has further appreciated by 18.9% against the U.S. dollar as of December 31, 2008. There can be no assurance that such exchange rate will not fluctuate widely against the U.S. dollar or any other foreign currency in the future. Fluctuation of the value of RMB will affect the amount of our non-RMB debt service in RMB terms since we have to convert RMB into non-RMB currencies to service our foreign debt. Since our income and profits are denominated in RMB, any appreciation of RMB will also increase the value of, and any dividends payable on, our ADSs in foreign currency terms. Conversely, any depreciation of RMB will decrease the value of, and any dividends payable on, our ADSs in foreign currency terms. Restrictions on currency exchange may limit our ability to receive dividends from our operating businesses in China and their ability to obtain overseas financing. Our operating businesses in China may convert a portion of RMB held by them into foreign currencies to meet its foreign currency obligations, including, among others, payments of dividends declared, if any, in respect of our ordinary shares. Under China s existing foreign exchange regulations, our operating businesses in China are able to pay dividends in foreign currencies without prior approval from the State Administration of Foreign Exchange, by complying with certain procedural requirements. However, we cannot assure you that China government will not take measures in the future to restrict access to foreign currencies for current account transactions, including payment of dividends. Foreign exchange transactions for capital account items, such as direct equity investments, loans and repatriation of investments, by our operating businesses in China continue to be subject to significant foreign exchange controls and require the approval of PRC governmental authorities, including the State Administration of Foreign Exchange. In particular, if our operating businesses in China borrow foreign currency-denominated loans from us or other foreign lenders, these loans must be registered with the local offices of the State Administration of Foreign Exchange. These limitations could affect their ability to obtain additional equity or debt funding that is denominated in foreign currencies. PRC regulation of direct investment and loans by offshore holding companies to PRC entities may delay or limit our ability to use the proceeds of this offering to make additional capital contributions or loans to our PRC operating businesses. Any capital contributions or loans that we, as an offshore company, make to our PRC operating businesses, including from the proceeds of this offering, are subject to PRC regulations. For example, any of our loans to our PRC operating businesses cannot exceed the difference between the total amount of investment our PRC operating businesses are approved to make under relevant PRC laws and their respective registered capital, and must be registered with the local branch of the State Administration of Foreign Exchange as a procedural matter. In addition, our capital contributions to our PRC operating businesses must be approved by the National Development and Reform Commission and the Ministry of Commerce or their local counterpart and registered with the State Administration for Industry and Commerce or its local counterpart. We cannot TABLE OF CONTENTS assure you that we will be able to obtain these approvals on a timely basis, or at all. If we fail to obtain such approvals, our ability to make equity contributions or provide loans to our PRC operating businesses or to fund their operations may be negatively affected, which could adversely affect their liquidity and their ability to fund their working capital and expansion projects and meet their obligations and commitments. Furthermore, the State Administration of Foreign Exchange promulgated a new circular in August 2008 with respect to the administration of conversion of foreign exchange capital contribution of foreign invested enterprises into RMB. Pursuant to this new circular, RMB converted from foreign exchange capital contribution can only be used for the activities within the approved business scope of such foreign invested enterprise and cannot be used for domestic equity investment or acquisition unless otherwise allowed by PRC laws or regulations. As a result, we may not be able to increase the capital contribution of our operating subsidiaries or equity investee and subsequently convert such capital contribution into RMB for equity investment or acquisition in China. PRC State Administration of Foreign Exchange ( SAFE ) Regulations regarding offshore financing activities by PRC residents may increase the administrative burden we face. The failure by our shareholders who are PRC residents to make any required applications and filings required by such regulations may prevent us from being able to distribute profits and could expose us and our PRC resident shareholders to liability under PRC law. SAFE, issued a public notice ( SAFE #75 ) effective from November 1, 2005, which requires our PRC resident shareholders to register with SAFE. If they do not register the PRC entity cannot remit any of its profits out of the PRC as dividends or otherwise. Our PRC resident largest shareholder, Mr. Du, has taken all necessary steps required by the local SAFE branch at Bazhou City to comply with SAFE #75 by filing a disclosure form regarding his ownership status; however, we cannot assure you that this disclosure document will be sufficient. It is also unclear exactly whether our other PRC resident shareholders must make disclosure to SAFE. While our PRC counsel has advised us that only the PRC resident shareholders who receive ownership of the foreign holding company in exchange for ownership in the PRC operating company are subject to SAFE #75, there can be no assurance that SAFE will not require our three other PRC resident shareholders to register and make the applicable disclosure. In addition, SAFE #75 requires that any monies remitted to PRC residents outside of the PRC be returned within 180 days; however, there is no indication of what the penalty will be for failure to comply or if shareholder non-compliance will be considered to be a violation of SAFE #75 by us or otherwise affect us. In the event that the proper procedures are not followed under SAFE #75, we could lose the ability to remit monies outside of the PRC and would therefore be unable to pay dividends or make other distributions. Our PRC resident shareholders could be subject to fines, other sanctions and even criminal liabilities under the PRC Foreign Exchange Administrative Regulations promulgated January 29, 1996, as amended. Because our principal assets are located outside of the United States and all of our directors and officers reside outside the United States, it may be difficult for you to enforce your rights based on U.S. Federal Securities Laws against us and our officers and some directors in the U.S. or to enforce a U.S. court judgment against us or them in the PRC. All of our directors and officers reside outside the United States. In addition, our operating subsidiaries, Deli Solar (Bazhou), Deli Solar (Beijing) and Tianjin Huaneng are located in the PRC and substantially all of their assets are located outside of the United States. It may therefore be difficult for investors in the United States to enforce their legal rights based on the civil liability provisions of the U.S. Federal securities laws against us in the courts of either the U.S. or the PRC and, even if civil judgments are obtained in U.S. courts, to enforce such judgments in PRC courts. Further, it is unclear if extradition treaties now in effect between the United States and the PRC would permit effective enforcement against us or our officers and directors of criminal penalties, under the U.S. Federal securities laws or otherwise. TABLE OF CONTENTS Risks Related to Our Common Stock We are not likely to pay cash dividends in the foreseeable future. We intend to retain any future earnings for use in the operation and expansion of our business. We do not expect to pay any cash dividends in the foreseeable future as we are contractually restricted from doing so. As a holding company, our ability to pay dividends and meet other obligations depends upon the receipt of dividends or other payments from our operating subsidiaries based in the PRC. Our PRC-based operating subsidiaries are subject to restrictions on their ability to make distributions to us, including restrictions on the conversion of local currency into U.S. dollars. Our common stock is thinly traded, so you may be unable to sell at or near ask prices or at all if you need to sell your shares to raise money or otherwise desire to liquidate your shares. Prior to the reverse merger our shares were not publicly traded although shares of the shell into whom we merged were thinly traded. Through the reverse merger, we have essentially become public without the typical initial public offering procedures which usually include a large selling group of broker-dealers who may provide market support after going public. We have undertaken efforts to develop market recognition for our stock, including through the retention of a public relations firm. As of May 21, 2009, there were 16,173,016 shares of our common stock issued and outstanding, and there were 2,515 holders of record of our outstanding shares of common stock. The market capitalization as of May 21, 2009 (excluding shares held by our affiliates) was approximately $6,134,437.64. As a result, there is limited market activity in our stock and we are too small to attract the interest of many brokerage firms and analysts. We cannot give you any assurance that a broader or more active public trading market for our common stock will develop or be sustained. Currently our common stock is quoted in the OTCBB market and the trading volume we will develop may be limited by the fact that many major institutional investment funds, including mutual funds, as well as individual investors follow a policy of not investing in OTCBB stocks and certain major brokerage firms restrict their brokers from recommending OTCBB stocks because they are considered speculative, volatile and thinly traded. The OTCBB market is an inter-dealer market much less regulated than the major exchanges and our common stock is subject to abuses and volatilities and shorting. Thus there is currently no broadly followed and established trading market for our common stock. An established trading market may never develop or be maintained. Active trading markets generally result in less price volatility and more efficient execution of buy and sell orders. Absence of an active trading market reduces the liquidity of the shares traded there. The trading volume of our common stock has been limited and sporadic. As a result of this trading activity, the quoted price for our common stock on the OTCBB may not necessarily be a reliable indicator of its fair market value. Further, if we cease to be quoted, holders would find it more difficult to dispose of, or to obtain accurate quotations as to the market value of our common stock and as a result, the market value of our common stock likely would decline. Our common stock is currently subject to the penny stock rules which require delivery of a schedule explaining the penny stock market and the associated risks before any sale. Our common stock is currently subject to regulations prescribed by the SEC relating to penny stocks. The SEC has adopted regulations that generally define a penny stock to be any equity security that has a market price (as defined in such regulations) of less than $5 per share, subject to certain exceptions. On June 26, 2009 the average of the ask and bid price of our common stock was $0.34 per share. These regulations impose additional sales practice requirements on broker-dealers who sell such securities to persons other than established customers and accredited investors (generally institutions with assets in excess of $5,000,000 and individuals with a net worth in excess of $1,000,000 or annual income exceeding $200,000 (individually) or $300,000 (jointly with their spouse)). For transactions covered by these rules, the broker-dealer must make a special suitability determination for the purchase of these securities and have received the purchaser's prior written consent to the transaction. Additionally, for any transaction, other than exempt transactions, involving a penny stock, the rules require the delivery, prior to the transaction, of a risk disclosure document mandated by the SEC relating to the penny stock market. The broker-dealer also must disclose the commissions payable to both the broker-dealer and the registered representative, current quotations for the securities and, if the broker-dealer is the sole market-maker, the broker-dealer must disclose this fact and the broker-dealer's presumed control over the market. Finally, monthly statements must be sent disclosing recent price information TABLE OF CONTENTS for the penny stock held in the account and information on the limited market in penny stocks. Consequently, the penny stock rules may restrict the ability of broker-dealers to sell the common stock and may affect the ability of investors to sell their common stock in the secondary market. Our common stock is illiquid and subject to price volatility unrelated to our operations. The market price of our common stock could fluctuate substantially due to a variety of factors, including market perception of our ability to achieve our planned growth, quarterly operating results of other companies in the same industry, trading volume in our common stock, changes in general conditions in the economy and the financial markets or other developments affecting our competitors or us. In addition, the stock market is subject to extreme price and volume fluctuations. This volatility has had a significant effect on the market price of securities issued by many companies for reasons unrelated to their operating performance and could have the same effect on our common stock. A large number of shares will be eligible for future sale and this may depress our stock price. This is an offering of 1,000,000 shares of our common stock by the selling stockholders. As of May 21, 2009, there were 16,173,016 shares of our common stock issued and outstanding and 90,000 shares of Series A Preferred Stock (all of which are held in escrow and which are in the process of being released to the company). Assuming (i) exercise of the 650,602 shares that may be acquired on exercise of all of the outstanding placement agent warrants, and (ii) the exercise of the other outstanding warrants to purchase an aggregate of 5,441,080 shares of common stock, there will be 23,164,698 shares of common stock outstanding. Of these 23,164,698 shares (i) 1,000,000 shares are being registered for resale in this prospectus, (ii) 4,691,499 shares were registered for resale in a registration statement declared effective on December 17, 2008; (iii) 3,952,025 shares were registered for resale in a registration statement declared effective on July 18, 2006; (iv) the 4,067,964 shares issued in the reverse merger may be sold subject to the requirements of Rule 144; and (v) 508,734 shares underlying the class A warrants were registered for resale in the registration statement declared effective on February 7, 2008 and all of the 1,734,194 shares underlying the class A warrants currently outstanding and all of the 1,774,194 shares underlying the class B warrants may now be resold if purchased by way of a cashless exercise. Sales of substantial amounts of common stock, or a perception that such sales could occur, and the existence of options or warrants to purchase shares of common stock at prices that may be below the then current market price of the common stock, could adversely affect the market price of our common stock and could impair our ability to raise capital through the sale of our equity securities. We are authorized to issue blank check preferred stock, which can be issued without stockholder approval and may adversely affect the rights of holders of our common stock. We are authorized to issue 25,000,000 shares of preferred stock, of which 3,500,000 shares have been designated as Series A Preferred Stock. As of June 10, 2009 there were 900,000 shares of Series A Preferred Stock (all of which are held in escrow and which are in the process of being released to the company). The Board of Directors is authorized under our Restated Articles of Incorporation to provide for the issuance of additional shares of preferred stock by resolution, and by filing a certificate of designations under Nevada law, to fix the designation, powers, preferences and rights of the shares of each such series and the qualifications, limitations or restrictions thereof without any further vote or action by the stockholders. Any shares of preferred stock so issued are likely to have priority over the common stock (but not the Series A Preferred Stock) with respect to dividend or liquidation rights. In the event of issuance, the preferred stock could be utilized, under certain circumstances, as a method of discouraging, delaying or preventing a change in control, which could have the effect of discouraging bids for our company and thereby prevent stockholders from receiving the maximum value for their shares. We have no present intention to issue any shares of this preferred stock in order to discourage or delay a change of control. However, there can be no assurance that preferred stock will not be issued at some time in the future. TABLE OF CONTENTS

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+RISK FACTORS You should carefully consider the risks described below before making a decision to buy our common stock. If any of the following risks actually occurs, our business, financial condition and results of operations could be harmed. In that case, the trading price of our common stock could decline and you might lose all or part of your investment in our common stock. You should also refer to the other information set forth in this prospectus, including our financial statements and the related notes. Risks Related to Our Business While we were profitable in 2008 and 2007, we incurred losses in 2006 and 2005. Our earnings are volatile, and we may not be profitable in the future. We incurred a loss of $1,000,000 in 2006 and $1,434,000 in 2005. Although we generated net income of approximately $4,556,000 in 2008 and $1,231,000 in 2007, there is no assurance that we will be able to maintain profitability in the future. Our ability to invest in sales and marketing programs, to expand and upgrade our technology infrastructure and to fund our research and development efforts will depend on existing cash balances and our ability to generate cash in the future. This, to a certain extent, is subject to general economic, financial, competitive, regulatory and other factors that are beyond our control. If we are unable to achieve or maintain profitability in the future, we may be unable to fund our liquidity needs. We may need additional financing in order to continue to develop our business. We may need additional financing to continue to fund the research and development of our software products and to expand and grow our business generally. To the extent that we will be required to fund operating losses, our financial position would deteriorate. If equity securities are issued in connection with a financing, dilution to our stockholders may result, and if additional funds are raised through the incurrence of debt, we may be subject to further restrictions on our operations and finances. Furthermore, if we do incur additional debt, we may be limiting our ability to repurchase capital stock, engage in mergers, consolidations, acquisitions and asset sales, or alter our lines of business, even though these actions might otherwise benefit our business. As of December 31, 2008, we had a net stockholders equity of approximately $7,804,000 and a net working capital of approximately $4,806,000. We depend on product development in order to remain competitive in our industry. We are currently investing resources in product development and expect to continue to do so in the future. Our future success will depend on our ability to continue to enhance our current product line and to continue to develop and introduce new products that keep pace with competitive product introductions and technological developments, satisfy diverse and evolving insurance industry requirements and otherwise achieve market acceptance. We may not be successful in continuing to develop and market, on a timely and cost-effective basis, product enhancements or new products that respond to technological advances by others. In addition, we have in the past experienced delays in the development, introduction and marketing of new and enhanced products, and we may experience similar delays in the future. Any failure by us to anticipate or respond adequately to changes in technology and insurance industry preferences, or any significant delays in product development or introduction, would significantly and adversely affect our business, operating results and financial condition. Our products may not achieve market acceptance, which may make it difficult for us to compete. Our future success will depend upon our ability to increase the number of insurance companies that license our software products. As a result of the intense competition in our industry and the rapid technological changes which characterize it, our products may not achieve significant market acceptance. Further, insurance companies are typically characterized by slow decision-making and numerous bureaucratic and institutional obstacles which will make our efforts to significantly expand our customer base difficult. Cover-All Technologies Inc. (Exact name of Registrant as specified in its charter) Delaware (State or other jurisdiction of incorporation or organization) 7371 (Primary Standard Industrial Classification Code number) 13-2698053 (I.R.S. Employer Identification No.) 55 Lane Road, Suite 300 Fairfield, New Jersey 07004 (973) 461-5200 (Address, including zip code, and telephone number, including area code, of Registrant s principal executive offices) We depend on key personnel. Our success depends to a significant extent upon a limited number of members of senior management and other key employees, including John W. Roblin, our Chief Executive Officer, Manish D. Shah, our President and Chief Technology Officer, and Maryanne Gallagher, our Executive Vice President and Chief Operating Officer. We maintain key man life insurance on Mr. Roblin, Mr. Shah and Ms. Gallagher in the amount of $1,000,000 per individual. The loss of the service of one or more key managers or other key employees could have a significant and adverse effect upon our business, operating results or financial condition. In addition, we believe that our future success will depend in large part upon our ability to attract and retain additional highly skilled technical, management, sales and marketing personnel. Competition for such personnel in the computer software industry is intense. We may not be successful in attracting and retaining such personnel, and the failure to do so could have a material adverse effect on our business, operating results or financial condition. Our products are affected by rapid technological change and we may not be able to keep up with these changes. The demand for our products is impacted by rapid technological advances, evolving industry standards in computer hardware and software technology, changing insurance industry requirements and frequent new product introductions and enhancements that address the evolving needs of the insurance industry. The process of developing software products such as those we offer is extremely complex and is expected to become increasingly complex and expensive in the future with the introduction of new platforms and technologies. The introduction of products embodying new technologies and the emergence of new industry standards and practices can render existing products obsolete and unmarketable. Our future success depends upon our ability to anticipate or respond to technological advances, emerging industry standards and practices in a timely and cost-effective manner. We may not be successful in developing and marketing new products or enhancements to existing products that respond to technological changes or evolving industry standards. The failure to respond successfully to these changes and evolving standards on a timely basis, or at all, could have a detrimental effect on our business, operating results and financial condition. Our market is highly competitive. Both the computer software and the insurance software systems industries are highly competitive. There are a number of larger companies, including computer manufacturers, computer service and software companies and insurance companies, that have greater financial resources than we have. These companies currently offer and have the technological ability to develop software products similar to those offered by us. These companies present a significant competitive challenge to our business. Because we do not have the same financial resources as these competitors, we may have a difficult time in the future in competing with these companies. In addition, very large insurers internally develop systems similar to our systems and as a result, they may not become customers of our software. We compete on the basis of our insurance knowledge, products, service, price, system functionality and performance and technological advances. Although we believe we can continue to compete on the basis of these factors, some of our current competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we do. Our current competitors may be able to: undertake more extensive marketing campaigns for their brands and services; devote more resources to product development; adopt more aggressive pricing policies; and make more attractive offers to potential employees and third-party service providers. We depend upon proprietary technology and we are subject to the risk of third party claims of infringement. Our success and ability to compete depends in part upon our proprietary software technology. We also rely on certain software that we license from others. We rely on a combination of trade secret, copyright and trademark laws, nondisclosure and other contractual agreements and technical measures to protect our John W. Roblin Chief Executive Officer Cover-All Technologies Inc. 55 Lane Road Fairfield, New Jersey 07004 (973) 461-5200 (Name, address, including zip code, and telephone number, including area code, of agent for service) proprietary rights. We currently have no patents or patent applications pending. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. The steps we take to protect our proprietary technology may not prevent misappropriation of our technology, and this protection may not stop competitors from developing products which function or have features similar to our products. While we believe that our products and trademarks do not infringe upon the proprietary rights of third parties, third parties may claim that our products infringe, or may infringe, upon their proprietary rights. Any infringement claims, with or without merit, could be time-consuming, result in costly litigation and diversion of technical and management personnel, cause product shipment delays or require us to develop non-infringing technology or enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all. If a claim of product infringement against us is successful and we fail or are unable to develop non-infringing technology or license the infringed or similar technology, our business, operating results and financial condition could be significantly and adversely affected. We depend on existing major customers, and the loss of one or more of which could have a material adverse effect on our results of operations and financial condition. In 2008 and 2007, our software products operations depended primarily on certain existing major customers. One of these major customers, a unit of AIG, accounted for approximately 15% and 19% of our total revenues in 2008 and 2007, respectively. One other major customer, a second unit of AIG, accounted for approximately 17% and 25% of our total revenues in 2008 and 2007, respectively. The other customer, a third unit of AIG, generated 27% of our total revenues for the year ended December 31, 2008. Two other customers, neither of which are units of AIG, generated approximately 13% and 11% of our revenues in 2006. We anticipate that our operations will continue to depend upon the continuing business of our existing customers, particularly the major customers, and the ability to attract new customers. Our contractual arrangements with these units of AIG, however, do not obligate any of them to continue to purchase from us any additional software license or professional services. Each of the three units of AIG has the obligation to continue to purchase our support services (which include our ASP services) during the applicable contractual term with such unit. The term with respect to our contractual arrangement to provide these services to the first of the AIG units referred to above will expire on March 31, 2010 and, unless the parties mutually agree otherwise, is subject to renewal or non-renewal seven months prior to the expiration date. The term with respect to our contractual arrangement to provide these services to the remaining two units of AIG will expire on September 30, 2012 and will automatically renew for successive one-year terms unless a party delivers a written notice of non-renewal to the other party at least 180 days prior to the expiration of the then current term. For the year ended December 31, 2008, the revenues we generated from such continuing support services (including our ASP services) for the three units of AIG represented approximately 12%, 4% and 2%, respectively, of our total revenues, and the total revenues we generated from the three units of AIG represented approximately 15%, 17% and 27%, respectively. See Business Major Customers . The loss of one or more of our existing major customers or our inability to continue to attract new customers could significantly and adversely affect our business, operating results and financial condition. A decline in computer software spending may result in a decrease in our revenues or lower our growth rate. A decline in the demand for computer software among our current and prospective customers may result in decreased revenues or a lower growth rate for us because our sales depend, in part, on our customers level of funding for new or additional computer software systems and services. Moreover, demand for our solutions may be reduced by a decline in overall demand for computer software and services. The current decline in overall technology spending may cause our customers to reduce or eliminate software and services spending and cause price erosion for our solutions, which would substantially affect our sales of new software licenses and the average sales price for these licenses. Because of these market and economic conditions, we believe there will continue to be uncertainty in the level of demand for our products and services. Accordingly, we cannot assure you that we will be able to increase or maintain our revenues. We may not get the full benefit of our tax credits. Under the United States Internal Revenue Code, companies that have not been operating profitably are allowed to apply certain of their past losses to offset future taxable income liabilities they may incur once they reach profitability. These amounts are known as net operating tax loss carryforwards. At December 31, 2008, we had approximately $21 million of federal net operating tax loss carryforwards expiring at various dates through 2026. Because of certain provisions of the Tax Reform Act of 1986 related to change of control, however, we may not get the full benefit of these loss carryforwards. If we are limited from using net operating tax loss carryforwards to offset any of our income, this would increase our taxes owed and reduce our cash for operations. Copies to: David E. Weiss, Esq. DLA Piper LLP (US) 1251 Avenue of the Americas New York, NY 10020 (212) 335-4500 Risks Related to Our Common Stock and This Offering Holders of our common stock may have difficulty in selling those shares. Our common stock is not traded on any securities exchange. Our common stock is quoted on the Over-the-Counter (OTC) Bulletin Board. Securities quoted on the OTC Bulletin Board do not enjoy the same liquidity as securities that trade on a securities exchange. As a result, you may have difficulty in selling shares of our common stock. In addition, our common stock is a penny stock as that term is defined in the Securities Exchange Act of 1934. Brokers effecting transactions in a penny stock are subject to additional customer disclosure and record keeping obligations, including disclosure of the risks associated with low price stocks, stock quote information and broker compensation. In addition, brokers effecting transactions in a penny stock are also subject to additional sales practice requirements under Rule 15g-9 of the Exchange Act including making inquiries into the suitability of penny stock investments for each customer or obtaining a prior written agreement for the specific penny stock purchase. Because of these additional obligations, some brokers will not effect transactions in penny stocks. Our stock price has been volatile. Quarterly operating results have fluctuated and are likely to continue to fluctuate significantly. The market price of our common stock has been and may continue to be highly volatile. Factors that are difficult to predict, such as quarterly revenues and operating results, limited trading volumes and overall market performance, will have a significant effect on the price of our common stock. Revenues and operating results have varied considerably in the past from period to period and are likely to vary considerably in the future. We plan product development and other expenses based on anticipated future revenue. If revenue falls below expectations, financial performance is likely to be adversely affected because only small portions of expenses vary with revenue. As a result, period-to-period comparisons of operating results are not necessarily meaningful and should not be relied upon to predict future performance. Our shares are subject to dilution as a result of the exercise of our warrants. An aggregate of 100,000 warrants, expiring in 2011, to purchase such number of shares of our common stock were outstanding as of March 31, 2009 and exercisable at a current exercise price of $0.35 per share. The current exercise price of these warrants is subject to adjustment if and whenever we issue or sell additional shares of our common stock for less than 95% of the market price on the date of issuance or sale, in which case the exercise price will be reduced to a new exercise price in accordance with the terms of the warrants. Pursuant to the terms of these warrants, the issuance or sale of additional shares of common stock resulting from the exercise of stock options to be granted in the future to employees or directors pursuant to our existing stock option plans outstanding on the date of the warrant will not trigger any adjustment to the exercise price of the warrants. The issuance of any additional shares of our common stock as a consequence of the exercise of any of the warrants may result in significant dilution to our stockholders and may depress the market price of our common stock. Further, if the exercise price of the warrants is adjusted, the additional shares of our common stock that would be issued upon exercise of the warrants as a result of such adjustment may also result in significant dilution to our stockholders. Provisions of our certificate of incorporation, as amended, and by-laws and Delaware law might discourage, delay or prevent a change of control of or changes in our management and, as a result, depress the trading price of our common stock. Our certificate of incorporation, as amended (the Certificate of Incorporation ), and by-laws contain provisions that could discourage, delay or prevent a change in control or changes in our management that our stockholders may deem advantageous. These provisions: require super-majority voting to amend some provisions in our Certificate of Incorporation and by-laws; establish a staggered board of directors; limit the ability of our stockholders to call special meetings of stockholders; Approximate date of commencement of proposed sale to the public: From time to time after the Registration Statement becomes effective. If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act, check the following box. [X] If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement number for the same offering. [ ] If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [ ] (Do not check if a smaller reporting company) Smaller reporting company [X] The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. prohibit stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders; provide that the board of directors is expressly authorized to make, alter or repeal our by-laws; and establish advance notice requirements for nominations for election to our board or for proposing matters that can be acted upon by stockholders at stockholder meetings. In addition, we are subject to Section 203 of the Delaware General Corporation Law, which, subject to some exceptions, prohibits business combinations between a Delaware corporation and an interested stockholder, which is generally defined as a stockholder who becomes a beneficial owner of 15% or more of a Delaware corporation s voting stock for a three-year period following the date that the stockholder became an interested stockholder. Section 203 could have the effect of delaying, deferring or preventing a change in control that our stockholders might consider to be in their best interests. These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing and cause us to take corporate actions other than those you desire. We may not pay any cash dividends on our common stock. Declaration and payment of any dividend on our common stock is subject to the discretion of our board of directors. The timing and amount of dividend payments will be dependent upon factors such as our earnings, financial condition, cash requirements and availability, and restrictions in our credit facilities. While we have historically paid a cash dividend, the payment of dividends is not guaranteed or assured. Accordingly, it is likely that investors may have to rely on sales of their common stock after price appreciation, which may never occur, as the only way to realize any future gains on their investment. The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted. Subject to Completion, dated , 2009

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+RISK FACTORS Investing in our debentures involves risks. The material risks and uncertainties that management believes affect us are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included in this prospectus. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impact us and our securities. If any of the following risks actually occurs, our business, results of operations and financial condition could be materially and adversely affected. If this were to happen, our ability to pay principal and interest on the debentures, and the value of the debentures, could decline significantly, and you could lose all or part of your investment. Risks Related to Our Operations and Business and Financial Strategies Our allowance for loan losses may be insufficient. We maintain an allowance for loan losses, which is a reserve established through a provision for possible loan losses charged to expense, that represents management s best estimate of probable losses within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio, and has been increasing as the economy worsens. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires management to make significant estimates of current credit risks and future trends, all of which may undergo material changes. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In light of the current economic environment, significant additional provisions for loan losses may be necessary to supplement the allowance for loan losses in the future. If charge-offs in future periods exceed the allowance for loan losses, we will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our financial condition and results of operations and hinder our ability to make payments on the debentures. A significant number of the loans in our portfolio are secured by real estate, and a continued downturn in the economy within the markets we serve could significantly hurt our business and prospects for growth. As of March 31, 2009, real estate loans comprised $506.9 million, or approximately 80.9% of our total loan portfolio (excluding loans held for sale) and approximately 61.5% of our total assets. Of that amount, $422.2 million consisted of commercial and residential real estate loans and $84.7 million consisted of construction real estate loans. The market value of real estate securing our real estate loans can fluctuate significantly in a short period of time as a result of market conditions. Adverse developments affecting real estate values in our primary market areas could increase the credit risk associated with our loan portfolio. In addition, the repayment of commercial real estate loans generally is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. Economic events or governmental regulations outside of our control or that of the borrower could negatively impact the future cash flow and market values of the affected properties. Beginning in 2007, the residential and commercial real estate sectors of the U.S. economy experienced an economic slowdown that has continued in 2009. Specifically, the values of residential and commercial real estate located in our market areas have declined, especially in our Central Indiana market, and these declines may continue in the future. If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then we may not be able to realize the full value of the collateral that we anticipated at the time of originating the loan, which could require us to increase our provision for loan losses and adversely affect our financial condition and results of operations. Further deterioration of our nonperforming loans or an increase in the number of non-performing loans may have an adverse effect on our operations. Weakening economic conditions in the residential and commercial real estate sectors have adversely affected, and may continue to adversely affect, our loan portfolio. The ratio of nonperforming assets and Table of Contents 90 day past due loans to total assets increased to 2.10% as of March 31, 2009, from 1.08% as of March 31, 2008. It is likely that this ratio will increase over the next several quarters as a result of the general economic environment as well as the progression of certain delinquent loans to loans that are 90 days or more past due. If loans that currently are non-performing further deteriorate or loans that are currently performing become nonperforming, we may need to increase our allowance for loan losses or charge-off those loans. Any increase or charge-off would have an adverse impact on our financial condition and results of operations and may adversely affect our ability to make payments on the debentures. The geographic concentration of our markets makes our business highly susceptible to local economic conditions. Unlike larger banking organizations that are more geographically diversified, our operations are currently concentrated in the Bloomington, Indiana and Central Indiana markets. As a result of this geographic concentration, our financial results depend largely upon economic conditions in these market areas. Deterioration in economic conditions in one or all of these markets could result in one or more of the following: an increase in loan delinquencies; an increase in non-performing loans and foreclosures; a decrease in the demand for our products and services; and a decrease in the value of collateral for loans, especially real estate, in turn reducing customers borrowing power, the value of assets associated with problem loans and collateral coverage. To date, the impact of the adverse economic conditions in our Central Indiana market has been severe. As a result, we have experienced asset quality issues in the Central Indiana market, and we expect to continue to experience higher levels of problem assets in this market unless the economy greatly improves. If current levels of market disruption and volatility continue in our Central Indiana market, or if our Bloomington, Indiana market suffers increased levels of market disruption and volatility, our problem assets may increase and the demand for our products and services could be adversely affected, which could in turn have a material adverse effect on our business, results of operations and financial condition. We are subject to interest rate risk. Our earnings and cash flows are largely dependent upon our net interest income. Net interest income is the difference between interest income earned on interest earning assets such as loans and securities and interest expense paid on interest bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and securities and the interest we pay on deposits and borrowings, but such changes could also affect (i) our ability to originate loans and obtain deposits, (ii) the fair value of our financial assets and liabilities, and (iii) the average duration of our mortgage-backed securities portfolio. Currently, we are in a liability-sensitive position. Therefore, if interest rates increase, the rates paid on deposits and other borrowings will increase at a faster rate than the interest rates received on loans and other investments, resulting in a decline in our net interest margin. If this happens, earnings could be adversely affected. In addition, due to the current low interest rate environment, interest rates paid on deposits are already approaching zero. If interest rates decrease, our liabilities will reprice downward more quickly than our assets. Because deposit pricing cannot become significantly lower than current levels, our net interest margin could decline in that case as well and earnings could be adversely affected. Liquidity risk could impair our ability to fund operations and jeopardize our financial condition. Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of securities or loans and other sources could have a substantial negative effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities on terms acceptable to us could be impaired by factors that affect us specifically or the financial services industry or the economy in general. For example, we could lose access to our federal funds lines, or the costs of such funds could increase. We might not be able to replace such funds in the future if, among other things, market conditions or our results of operations or financial condition were to change. Table of Contents Slower than anticipated growth in the Bank s new branches could result in reduced net income. We opened full service branches in Brownsburg, Hendricks County, Indiana, in January 2006, Plainfield, Hendricks County, Indiana in December 2007, Avon, Hendricks County, Indiana in January 2008, and Noblesville, Hamilton County, Indiana in September 2008. New branches require a significant investment of both financial and personnel resources and lower than expected loan and deposit growth in the new branches could result in lower than expected revenues and net income generated by those investments. Opening new branches results in additional expenses and diverts resources from current core operations. None of the four branches is showing a profit, and we are unable to predict when, or if, they will achieve profitability. Future growth or operating results may require us to raise additional capital but that capital may not be available or it may be dilutive. We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. Although we expect to raise $12.0 million in this offering, to the extent our future operating results erode capital or we elect to expand through loan growth or acquisitions, we may be required to raise additional capital. Our ability to raise capital will depend on conditions in the capital markets, which are outside of our control, and on our financial performance. Accordingly, we cannot be assured of our ability to raise capital when needed or on favorable terms. If we cannot raise additional capital when needed, we will be subject to increased regulatory supervision and the imposition of restrictions on our growth and business. These could negatively impact our ability to operate or further expand our operations through acquisitions or the establishment of additional branches and may result in increases in operating expenses and reductions in revenues that could have a material adverse effect on our financial condition and results of operations. Difficult conditions in the capital markets, the credit markets and the economy in general may materially adversely affect our business, results of operations and financial condition. Our results of operations are materially affected by conditions in the capital markets and the economy in general. The capital and credit markets have been experiencing extreme volatility and disruption for more than twelve months at unprecedented levels. In many cases, these markets have produced downward pressure on stock prices of, and credit availability to, certain companies without regard to those companies underlying financial strength. Recently, concerns over inflation, energy costs, geopolitical issues, the availability and cost of credit, the U.S. mortgage market and a declining U.S. real estate market have contributed to increased volatility and diminished expectations for the economy and the capital and credit markets going forward. These factors, combined with volatile oil prices, declining business and consumer confidence and increased unemployment, have precipitated an economic slowdown and national recession. In addition, the fixed-income markets are experiencing a period of extreme volatility which has negatively impacted market liquidity conditions. Initially, the concerns on the part of market participants were focused on the subprime segment of the mortgage-backed securities market. However, these concerns have since expanded to include a broad range of mortgage-and asset-backed and other fixed income securities, including those rated investment grade, the U.S. and international credit and interbank money markets generally, and a wide range of financial institutions and markets, asset classes and sectors. Factors such as consumer spending, business investment, government spending, the volatility and strength of the capital markets, and inflation all affect the business and economic environment and, ultimately, the amount and profitability of our business. In an economic downturn characterized by higher unemployment, lower family income, lower corporate earnings, lower business investment and lower consumer spending, the demand for our financial products could be adversely affected. Adverse changes in the economy could affect earnings negatively and could have a material adverse effect on our business, results of operations and financial condition. The current mortgage crisis and economic slowdown has also raised the possibility of future legislative and regulatory actions in addition to the recent enactment of the Emergency Economic Stabilization Act of 2008 ( EESA ) and the American Recovery and Reinvestment Act of 2009 ( ARRA ) that could further impact our business. We cannot predict whether or when such actions may occur, or what impact, if any, such actions could have on our business, results of operations and financial condition. Table of Contents There can be no assurance that actions of the U.S. Government, Federal Reserve and other governmental and regulatory bodies for the purpose of stabilizing the financial markets will achieve the intended effect. In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, President Bush signed EESA into law. Pursuant to EESA, the Treasury has the authority to utilize up to $700 billion to purchase distressed assets from financial institutions or infuse capital into financial institutions for the purpose of stabilizing the financial markets. The Treasury announced the Capital Purchase Program under EESA pursuant to which it has purchased and will continue to purchase senior preferred stock or subordinated debt from participating financial institutions. Although we applied to participate in the Capital Purchase Program, we withdrew our application prior to receiving approval from the Treasury to proceed. There can be no assurance as to the actual impact that EESA, including the Capital Purchase Program, will have on the financial markets or on us. The failure of these programs to help stabilize the financial markets and a continuation or worsening of current financial market conditions could have a material adverse effect on our business, results of operations and financial condition. The federal government, Federal Reserve and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis. On February 17, 2009, President Obama signed ARRA into law. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs. There can be no assurance as to what impact such actions will have on the financial markets, including the extreme levels of volatility currently being experienced. Such continued volatility could have a material adverse effect on our business, results of operations and financial condition. We are subject to extensive government regulation and supervision. We, primarily through the Bank, are subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors funds, federal deposit insurance funds and the banking system as a whole, not shareholders or holders of debentures. These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on our business, results of operations and financial condition. As a result of the recent global financial crisis, the potential exists for new federal or state laws and regulations regarding lending and funding practices and liquidity standards to be promulgated, and bank regulatory agencies are expected to be active in responding to concerns and trends identified in examinations, including the expected issuance of many formal enforcement orders. Negative developments in the financial industry and the domestic and international credit markets, and the impact of new legislation in response to those developments, may negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and may adversely impact our financial performance. We may be required to pay significantly higher FDIC premiums in the future. Recent insured institution failures, as well as deterioration in banking and economic conditions, have significantly increased the loss provisions of the Federal Deposit Insurance Corporation (the FDIC ), resulting in a decline in the designated reserve ratio to historical lows. The FDIC expects a higher rate of insured institution failures in the next few years compared to recent years; thus, the reserve ratio may continue to decline. In addition, EESA temporarily increased the limit on FDIC coverage to $250,000 through December 31, 2009. On May 20, 2009, the temporary increase on the limit of FDIC coverage was extended to December 31, 2013. These developments will cause the premiums assessed on us by the FDIC to increase and materially increase our other expense. On December 16, 2008, the FDIC Board of Directors determined deposit insurance assessment rates for the first quarter of 2009 at 12 to 14 basis points per $100 of deposits. Beginning April 1, 2009, the rates Table of Contents increased to 12 to 16 basis points per $100 of deposits. Additionally, on May 22, 2009, the FDIC announced a final rule imposing a 5 basis point special emergency assessment on June 30, 2009, payable September 30, 2009. The amount of the assessment will be $0.05 for each $100 of assets, less Tier 1 capital, as of June 30, 2009, but the amount of the assessment is capped at 10 basis points of domestic deposits. The final rule also allows the FDIC to impose additional special emergency assessments on or after September 30, 2009, of up to 5 basis points per quarter, if necessary to maintain public confidence in FDIC insurance. The FDIC has indicated that a second assessment is probable. These higher FDIC assessment rates and special assessments will have an adverse impact on our results of operations. Presently, we anticipate our FDIC insurance related costs (assuming the 5 basis point special emergency assessment on June 30, 2009, payable September 30, 2009, is the only special assessment in 2009) to increase to $1.5 million in 2009 from $481,000 in 2008 and $69,000 in 2007, and we are unable to predict the impact in future periods in the event the economic crisis continues. Competition may adversely affect our business. Our market areas are highly competitive. In addition to competition from commercial banks (including certain larger regional banks) and savings associations, we also compete with numerous credit unions, finance companies, insurance companies, mortgage companies, securities and brokerage firms, money market mutual funds, loan production offices and other providers of financial services. We compete with these firms in terms of pricing, delivery channels, product features, service quality, responsiveness and other factors. We also compete directly with a large number of financial service providers who do not have a physical presence in our markets but have been successful in selling their services using technology and sophisticated target marketing techniques. We fully expect these companies to increase their future efforts to attract business from our customers. Increasing competition may decrease the prices we can charge for our services or cause us to pay higher rates for customer deposits. Additionally, we are continuously required to update our technology products (such as internet banking and remote deposit capture) to meet our customers needs and demands, in order to retain those customers. Although our costs for these technology products may increase, we may be unable to pass along the cost of those products to our customers. Many of our competitors possess substantially greater financial resources and lending limits than we do, and they may provide services to their customers that we do not offer. These factors, alone or in combination with others, may have an adverse effect on our business, results of operations and financial condition. Inability to hire or retain certain key professionals, management and staff could adversely affect our revenues and net income. We rely on key personnel to manage and operate our business, including major revenue generating functions such as the loan and deposit portfolios. The loss of key staff may adversely affect our ability to maintain and manage these portfolios effectively, which could negatively affect our revenues. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause a decrease in our net income. We are subject to environmental liability risk associated with our properties and lending activities. We own a number of our bank office properties. In addition, a significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. There is a risk that hazardous or toxic substances could be found on any of these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations. Our controls and procedures may fail or be circumvented. Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and Table of Contents operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition. Our information systems may experience an interruption or breach in security. We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations. We are also dependent on third-party service providers for data processing and other information processing systems that support our day-to-day banking, investment, and trust activities that are integral to our banking relationships with our customers. Any disruption in the services provided by these third parties could have an adverse effect on our operations and our ability to meet our customers needs. Risks Relating to this Offering and the Debentures The debentures are unsecured, and we cannot make payments under the debentures if we default on our more senior obligations. The debentures are not secured by any of our assets, and our obligations under the debentures rank junior to all of our other borrowings, except those borrowings that by their terms rank equal or junior to the debentures, including our junior subordinated debentures in the aggregate principal amount of $3.1 million issued to Monroe Bancorp Capital Trust I, and our junior subordinated debentures in the aggregate principal amount of $5.2 million issued to Monroe Bancorp Statutory Trust II, which will rank junior to the debentures being offered in this prospectus. This means that we cannot pay principal or interest under the debentures if we default on payments under any of our other borrowings, unless by their terms, those borrowings rank equal or junior to the debentures. In addition, if the maturity of the debentures is accelerated upon the occurrence of certain events, such as our filing for bankruptcy, we cannot make payments on the debentures without the prior approval of the Federal Reserve, if required, and not until all of our more senior borrowings are paid in full. Finally, if we liquidate, are placed in receivership or dissolve, or enter bankruptcy proceedings, we would be able to make payments on the debentures only after we have paid all of our liabilities senior to the debentures. The debentures are subject to limited rights of acceleration and may be accelerated only in the event of our bankruptcy or the receivership of the Bank. Payment of principal of the debentures may be accelerated by the trustee or the holders of the debentures only in the case of certain events, such as our filing for bankruptcy. Thus, you have no right to accelerate the payment of principal of the debentures if we fail to pay interest on the debentures or if we fail in the performance of any of our other obligations under the debentures or the indenture. Our holding company structure effectively subordinates any claims of the holders of the debentures against us to those of our subsidiaries creditors. Because we are a holding company, the creditors of our subsidiaries, including depositors of the Bank, will have priority over the claims of the holders of the debentures in any distribution of our subsidiaries assets in liquidation, reorganization or otherwise. We receive substantially all of our revenue from dividends from the Bank. Because we are a holding company, our right to participate in any distribution of the assets of our banking or nonbanking subsidiaries, upon a subsidiary s dissolution, winding-up, liquidation or reorganization or otherwise, and thus your ability to benefit indirectly from such distribution, is subject to the prior claims of creditors of any such subsidiary (including depositors), except to the extent that we may be a Table of Contents creditor of that subsidiary and our claims are recognized. There are legal limitations on the extent to which some of our subsidiaries may extend credit, pay dividends or otherwise supply funds to, or engage in transactions with, us or some of our other subsidiaries. Our subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay amounts due under our contracts or otherwise to make any funds available to us. Accordingly, the debentures will be effectively subordinated to all existing and future liabilities of our subsidiaries. As of March 31, 2009, we had approximately $759.5 million outstanding principal amount of liabilities (including deposit liabilities of the Bank) to which the debentures are effectively subordinated. We have made only limited covenants in the indenture, which may not protect your investment in the event we experience significant adverse changes in our financial condition or results of operations. The covenants in the indenture governing the debentures are extremely limited. For example, the indenture does not require us to maintain any financial ratios or specified levels of net worth, revenues, income, cash flow or liquidity, and therefore does not protect holders of the debentures in the event we experience significant adverse changes in our financial condition or results of operations. The indenture does not prevent us or any subsidiary from borrowing money, issuing securities, or otherwise incurring future indebtedness that has rights to payment that are expressly or effectively senior to, or equal with, the rights of payment of the holders of the debentures. Our incurrence of additional indebtedness potentially could diminish the resources we have to service our indebtedness, including the debentures. Therefore, you should not consider the provisions of the indenture a significant factor in evaluating whether we will be able to comply with our obligations under the debentures. We will not be limited in our ability to incur additional indebtedness. Neither the indenture nor the debentures limit our ability or the ability of our subsidiaries to incur additional indebtedness, guarantees or other liabilities in the future. Any additional indebtedness may rank senior, equal or junior to the debentures. Our incurrence of additional indebtedness, even if it is junior to the debentures, potentially could diminish the resources we have to service our then existing indebtedness, including the debentures. Our ability to make interest payments on the debentures may be restricted. We intend to invest at least $10.0 million of the proceeds from this offering in the Bank. Our ability to make interest and principal payments on the debentures will be dependent upon dividends we receive from the Bank. Under Indiana law, the Bank may pay dividends from its undivided profits in an amount declared by its board of directors, subject to prior approval of the Indiana Department of Financial Institutions (the DFI ) if the proposed dividend, when added to all prior dividends declared during the current calendar year, would be greater than the current year s net profits and retained net profits for the previous two calendar years. Federal law generally prohibits the Bank from paying a dividend to our holding company if the depository institution would thereafter be undercapitalized. The FDIC may prevent an insured bank from paying dividends if the bank is in default of payment of any assessment due to the FDIC. In addition, payment of dividends by a bank may be prevented by the applicable federal regulatory authority if such payment is determined, by reason of the financial condition of such bank, to be an unsafe and unsound banking practice. Under these circumstances, federal or state banking authorities have the authority to issue orders that could restrict the ability of the Bank to pay sufficient dividends to us in order to allow us to make payment under the debentures. In addition, as a bank holding company, we are expected to act as a source of financial strength to the Bank and to commit resources to support the operations of the Bank. If we need to commit additional resources to support the operations of the Bank, our ability to make interest payments on the debentures may be limited. The debentures are not deposits and are not insured by the FDIC. The debentures are unsecured, subordinated obligations of our company and not the Bank. The debentures are not bank deposits and, therefore, are not insured against loss by the FDIC, any deposit insurance fund or any other agency. The debentures are not guaranteed by any person or entity. In addition, because the debentures are subordinated debt, they are not eligible to be guaranteed by the FDIC under the FDIC s Debt Guarantee Program ( DGP ) discussed elsewhere in this prospectus. If you acquire the Table of Contents debentures, your investment is not insured or guaranteed and, therefore, you may lose some or all of the value of your investment. The secondary market for the debentures may be illiquid. The debentures will not be listed on any securities exchange. Although we currently expect the debentures to be listed on the Pink Sheets, we do not expect an active trading market for the debentures to develop. As a result, holders of the debentures likely will not be able to resell their debentures and thus should be prepared to hold the debentures until the maturity date. The debentures are not a suitable investment for investors that may need liquidity prior to the maturity date. In the event we redeem the debentures before , 2019, you may not be able to reinvest your principal at the same or a higher rate of return. We may redeem the debentures, in whole or in part, and without premium or penalty, at any time on or after , 2012, subject to certain conditions. You should assume that we will exercise our redemption option if we are able to obtain capital at a lower cost than we must pay on the debentures or if it is otherwise in our interest to redeem the debentures. If the debentures are redeemed, you may be required to reinvest your principal at a time when you may not be able to earn a return that is as high as you were earning on the debentures. We have broad discretion in the use of the net proceeds from this offering. We will have broad discretion in determining how the proceeds of the offering will be used by the Bank (to which the first $10.0 million of the net proceeds of this offering will be contributed) and by us. While our board of directors believes the flexibility in application of the net proceeds is prudent, the broad discretion it affords entails increased risks to the investors in this offering. Investors in this offering have no current basis to evaluate the possible merits or risks of any application of the net proceeds of this offering and may not agree with the manner in which we choose to allocate and spend the net proceeds.

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+RISK FACTORS An investment in our common stock involves certain risks. You should carefully consider the risks described below, as well as the other information included or incorporated by reference in this prospectus, before making an investment decision. Additional risks and uncertainties not presently known to us or that we currently do not deem to be material may also impair our business operations. If any of these risks actually occurs, our business, financial condition or results of operations could be materially adversely affected. In that case, the trading price of our common stock could decline substantially, and you may lose all or part of your investment. The risks discussed below include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements. Risks Relating to Our Business The current economic environment poses significant challenges and could adversely affect our financial condition and results of operations. There was significant disruption and volatility in the financial and capital markets during 2008 and 2009. The financial markets and the financial services industry in particular suffered unprecedented disruption, causing a number of institutions to fail or require government intervention to avoid failure. These conditions were largely the result of the erosion of the U.S. and global credit markets, including a significant and rapid deterioration in mortgage lending and related real estate markets. Continued declines in real estate values, high unemployment and financial stress on borrowers as a result of the uncertain economic environment could have an adverse effect on our borrowers or their customers, which could have a material adverse effect on our business, prospects, financial condition and results of operations. As a consequence of the difficult economic environment, we experienced a significant decrease in earnings resulting primarily from increased provisions for loan losses. There can be no assurance that the economic conditions that have adversely affected the financial services industry, and the capital, credit and real estate markets generally, will improve in the near term, in which case we could continue to experience write-downs of assets, and could face capital and liquidity constraints or other business challenges. A further deterioration in economic conditions, particularly within our market areas, could result in the following consequences, any of which could have a material adverse effect on our business, prospects, financial condition and results of operations: Loan delinquencies may further increase causing additional increases in our provision and allowance for loan losses. Our ability to assess the creditworthiness of our customers may be impaired if the models and approaches we use to select, manage, and underwrite our customers become less predictive of future charge-offs. Collateral for loans made by MidSouth Bank, especially real estate, may continue to decline in value, in turn reducing a customer s borrowing power, and reducing the value of assets and collateral associated with our loans. Consumer confidence levels may decline and cause adverse changes in payment patterns, resulting in increased delinquencies and default rates on loans and other credit facilities and decreased demand for our products and services. Our market areas are heavily dependent on, and we have significant credit exposure to, the oil and gas industry. The economy in a large portion of our market areas is heavily dependent on the oil and gas industry. Many of our customers provide transportation and other services and products that support oil and gas exploration and production activities. Accordingly, as of September 30, 2009, we had approximately $121.2 million in loans to Table of Contents borrowers in the oil and gas industry, representing approximately 20.6% of our total loans outstanding as of that date. The oil and gas industry, especially in Louisiana and Texas, has been subject to significant volatility, including the oil bust of the 1980s that severely impacted the economies of many of our market areas. Recently, President Obama s administration proposed a number of legislative changes that could significantly impact the oil and gas industry, including the elimination of certain tax breaks, such as the intangible drilling and development costs, percentage depletion and manufacturing deduction, and the implementation of an excise tax focused specifically on production in the Gulf of Mexico. If there is a significant downturn in the oil and gas industry, generally the cash flows of our customers in this industry would be adversely impacted which could impair their ability to service our loans outstanding to them and reduce demand for loans. This could have a material adverse effect on our business, prospects, financial condition and results of operations. We may suffer losses in our loan portfolio in excess of our allowance for loan losses. We have experienced increases in the levels of our non-performing assets and loan charge-offs in recent periods. Our total non-performing assets amounted to $18.0 million, or 1.90% of our total assets, at September 30, 2009 and $11.0 million, or 1.17% of our total assets, at December 31, 2008. We had $3.7 million of net loan charge-offs for the nine months ended September 30, 2009 compared to $1.7 million for the nine months ended September 30, 2008. Our provision for loan losses was $4.1 million for the nine months ended September 30, 2009, compared to $2.6 million for the nine months ended September 30, 2008. At September 30, 2009, the ratios of our allowance for loan losses to non-performing loans and to total loans outstanding was 46.82% and 1.36%, respectively, compared to 73.22% and 1.25%, respectively, at December 31, 2008. Additional increases in our non-performing assets or loan charge-offs could have a material adverse effect on our financial condition and results of operations. We seek to mitigate the risks inherent in our loan portfolio by adhering to specific underwriting practices. These practices include analysis of a borrower s prior credit history, financial statements, tax returns and cash flow projections, valuation of collateral based on reports of independent appraisers and verification of liquid assets. Although we believe that our underwriting criteria are appropriate for the various kinds of loans we make, we still may incur losses on loans that meet our underwriting criteria, and these losses may exceed the amounts set aside as reserves in our allowance for loan losses. We create an allowance for estimated loan losses in our accounting records, based on, among other considerations, the following: industry historical losses as reported by the FDIC; historical experience with our loans; evaluation of economic conditions; regular reviews of the quality mix, including our distribution of loans by risk grade within our portfolio, and size of our overall loan portfolio; regular reviews of delinquencies; and the quality of the collateral underlying our loans. Although we maintain an allowance for loan losses at a level that we believe is adequate to absorb losses inherent in our loan portfolio, changes in economic, operating and other conditions, including conditions which are beyond our control such as a sharp decline in real estate values and changes in interest rates, may cause our actual loan losses to exceed our current allowance estimates. Additions to the allowance for loan losses could result in a decrease in net earnings and capital and could hinder our ability to grow. Further, if our actual loan losses exceed the amount reserved, it could have a material adverse effect on our financial condition and results of operations. Table of Contents We cannot predict the effect of recent or future legislative and regulatory initiatives. Financial institutions have been the subject of substantial legislative and regulatory changes and may be the subject of further legislation or regulation in the future, including (i) changes in banking, securities and tax laws and regulations and their application by our regulators, (ii) changes in the scope and cost of FDIC insurance and other coverages, and (iii) changes in the CPP, none of which is within our control. Significant new laws or regulations or changes in, or repeals of, existing laws or regulations may cause our results of operations to differ materially from those we currently anticipate. In addition, the cost and burden of compliance with applicable laws and regulations have significantly increased and could adversely affect our ability to operate profitably. Further, federal monetary policy significantly affects credit conditions for us, as well as for our borrowers, particularly as implemented by the Federal Reserve Board, primarily through open market operations in U.S. government securities, the discount rate for bank borrowings and reserve requirements. A material change in any of these conditions could have a material impact on us or our borrowers, and therefore on our business, prospects, financial condition and results of operations. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 ( EESA ) was enacted in an effort to stabilize the financial markets. Pursuant to the EESA, Treasury was granted the authority to take a range of actions for the purpose of stabilizing and providing liquidity to the U.S. financial markets and has proposed several programs in addition to TARP, including the purchase by the Treasury of certain troubled assets from financial institutions. There can be no assurance, however, as to the actual impact that the foregoing or any other governmental program will have on the financial markets. The failure of the financial markets to stabilize and a continuation or worsening of current financial market conditions could have a material adverse effect on our business, prospects, financial condition, results of operations, access to credit or the trading price of our common stock. In addition, current initiatives of President Obama s administration with respect to the financial services industry could have a material adverse effect on our business, prospects, financial condition and results of operations. We expect to face increased regulation and supervision of our industry as a result of the existing financial crisis, and there may be additional requirements and conditions imposed on us as a result of our issuance of the Series A Preferred Stock in the TARP Transaction. Such additional regulation and supervision may increase our costs and limit our ability to pursue business opportunities. The affects of such recently enacted, and proposed, legislation and regulatory programs on us cannot reliably be determined at this time. We have a concentration of exposure to a number of individual borrowers. Given the size of these loan relationships relative to capital levels and earnings, a significant loss on any one of these loans could materially and adversely affect us. We have a concentration of exposure to a number of individual borrowers. Our largest exposure to one borrowing relationship as of September 30, 2009, was approximately $12.5 million, which is 12.9% of our total capital. In addition, as of September 30, 2009, the aggregate exposure to the ten largest borrowing relationships was approximately $67.7 million, which was 69.5% of total capital. As a result of this concentration, a change in the financial condition of one or more of these borrowers could result in significant loan losses and have a material adverse effect on our financial condition and results of operations. A large percentage of our deposits is attributable to a relatively small number of customers. The loss of all or some of these customers or a significant decline in their deposit balances may have a material adverse effect on our liquidity and results of operations. Our 20 largest depositors accounted for approximately 18.2% of our total deposits and our five largest depositors accounted for approximately 9.9% of our total deposits as of September 30, 2009. The ability to attract these types of deposits has a positive effect on our net interest margin as they provide a relatively low cost of funds to the Bank. While we believe we have strong, long-term relationships with each of these customers, the loss of one or more of our 20 largest customers, or a significant decline in the deposit balances would adversely Table of Contents affect our liquidity and require us to attract new deposits, purchase federal funds or borrow funds on a short term basis to replace such deposits, possibly at interest rates higher than those currently paid on these deposits. This could increase our total cost of funds and could result in a decrease in our net interest income and net earnings. If we were unable to develop alternative funding sources, we may have difficulty funding loans or meeting other deposit withdrawal requirements. We occasionally purchase non-recourse loan participations from other banks based in part on information provided by the selling bank. From time to time, we purchase loan participations from other banks in the ordinary course of business, usually without recourse to the selling bank. As of September 30, 2009, we had approximately $49.4 million in purchased loan participations. When we purchase loan participations we apply the same underwriting standards as we would to loans that we directly originate and seek to purchase only loans that would satisfy these standards. However, we are less likely to be familiar with the borrower and may rely to some extent on information provided to us by the selling bank and typically must rely on the selling bank s administration of the loan relationship. We therefore have less control over, and may incur more risk with respect to, loan participations that we purchase from selling banks as compared to loans that we originate. Our focus on lending to small to mid-sized community-based businesses may increase our credit risk. Most of our commercial business and commercial real estate loans are made to small business or middle market customers. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities and have a heightened vulnerability to economic conditions. If general economic conditions in the markets in which we operate negatively impact this important customer sector, our results of operations and financial condition and the value of our common stock may be adversely affected. Moreover, a portion of these loans have been made by us in recent years and the borrowers may not have experienced a complete business or economic cycle. Furthermore, the deterioration of our borrowers businesses may hinder their ability to repay their loans with us, which could have a material adverse effect on our financial condition and results of operations. Our loan portfolio includes a substantial percentage of commercial and industrial loans, which may be subject to greater risks than those related to residential loans. Our loan portfolio includes a substantial percentage of commercial and industrial loans. Commercial and industrial loans generally carry larger loan balances and historically have involved a greater degree of financial and credit risks than residential first mortgage loans. Repayment of our commercial and industrial loans is often dependent on cash flow of the borrower, which may be unpredictable, and collateral securing these loans may fluctuate in value. Our commercial and industrial loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Most often, this collateral is accounts receivable, inventory, equipment, or real estate. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Other collateral securing loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. At September 30, 2009, commercial and industrial loans totaled approximately 33.4% of our total loan portfolio. Adverse changes in local economic conditions impacting our business borrowers could have a material adverse effect on our business, prospects, financial condition and results of operations. We have a high concentration of loans secured by real estate, and the current downturn in the real estate market could have a material adverse effect on our financial condition and results of operations. A significant portion of our loan portfolio is dependent on real estate. At September 30, 2009, approximately 51% of our loans had real estate as a primary or secondary component of collateral. The collateral in each case provides an alternate source of repayment if the borrower defaults and may deteriorate in value during the time Table of Contents the credit is extended. An adverse change in the economy affecting values of real estate in our primary markets could significantly impair the value of real estate collateral and the ability to sell real estate collateral upon foreclosure. Furthermore, it is likely that we would be required to increase the provision for loan losses. A related risk in connection with loans secured by real estate is the effect of unknown or unexpected environmental contamination, which could make the real estate effectively unmarketable or otherwise significantly reduce its value as collateral. If we were required to liquidate real estate collateral securing a loan to satisfy the debt during a period of reduced real estate values or to increase the allowance for loan losses, it could have a material adverse effect on our financial condition and results of operations. We may face risks with respect to future expansion and acquisition opportunities. We have expanded our business in part through acquisitions and will continue to look at future acquisitions as a way to further increase our growth. However, we cannot assure you that we will be successful in completing any future acquisitions. Further, failure to realize the potential expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on our business, prospects, financial condition and results of operations. We may seek merger or acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale or expanded services. We do not currently have any specific plans, arrangements or understandings regarding such expansion. We cannot say with any certainty that we will be able to consummate, or if consummated, successfully integrate future acquisitions or that we will not incur disruptions or unexpected expenses in integrating such acquisitions. In attempting to make such acquisitions, we anticipate competing with other financial institutions, many of which have greater financial and operational resources. Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things: potential exposure to unknown or contingent liabilities of the target company; potential challenges associated with operating in new markets that may have different characteristics than our current markets; exposure to potential asset quality issues of the target company; difficulty and expense of integrating the operations and personnel of the target company; potential disruption to our business; potential diversion of management s time and attention; the possible loss of key employees and customers of the target institution; difficulty in estimating the value of the target company; and potential changes in banking, accounting or tax laws or regulations that may affect the target institution. If we acquire the assets and liabilities of one or more target banks that are in receivership through the FDIC bid process for failed institutions, such an acquisition will require us, through our bank subsidiary, to enter into a Purchase & Assumption Agreement (the P&A Agreement ) with the FDIC. The P&A Agreement is a form document prepared by the FDIC, and our ability to negotiate the terms of this agreement is extremely limited. As a result, we expect that any P&A Agreement would provide for limited disclosure about, and limited indemnification for, risks associated with the target banks. There is a risk that such disclosure regarding, and indemnification for, the assets and liabilities of target banks will not be sufficient and we will incur unanticipated losses. There is also a risk that we may be required to make an additional payment to the FDIC under certain circumstances following the completion of an FDIC-assisted acquisition if, for example, actual losses related to the target bank s assets acquired are substantially less than expected at the time the P&A Agreement was entered into. In addition, the FDIC bid process for failed depository institutions is competitive. We cannot provide any assurances that we will be successful in bidding for any target bank or for other failed depository institutions. Table of Contents Our future earnings could be adversely affected by non-cash charges for goodwill impairment, if a future test of goodwill indicates that goodwill has been impaired. As prescribed by Accounting Standards Codification ( ASC ) Topic 350, Intangibles Goodwill and Other, we undertake an annual review of the goodwill asset balance reflected in our financial statements. We conduct an annual review in the fourth quarter of each year, unless there has been a triggering event prescribed by applicable accounting rules that warrants an earlier interim testing for possible goodwill impairment. During the first quarter of 2009, we conducted an interim test and, upon review and analysis of the factors influencing value and utilizing the market value and investment value approaches, concluded there was no goodwill impairment as of such date. During the second and third quarters of 2009, our goodwill was not evaluated for impairment since we determined no triggering events have occurred during these quarters. As of September 30, 2009, we had $9.5 million in goodwill. Future goodwill impairment tests may result in future non-cash charges, which could adversely affect our earnings for any such future period. Changes in the fair value of our securities may reduce our shareholders equity and net income. At September 30, 2009, $218.8 million of our securities (at fair value) were classified as available-for-sale. At such date, the aggregate net unrealized gain on our available-for-sale securities was $7.6 million. We increase or decrease shareholders equity by the amount of change from the unrealized gain or loss (the difference between the estimated fair value and the amortized cost) of our available-for-sale securities portfolio, net of the related tax, under the category of accumulated other comprehensive income/loss. Therefore, a decline in the estimated fair value of this portfolio will result in a decline in reported shareholders equity, as well as book value per common share and tangible book value per common share. This decrease will occur even though the securities are not sold. In the case of debt securities, if these securities are never sold and there are no credit impairments, the decrease will be recovered over the life of the securities. In the case of equity securities which have no stated maturity, the declines in fair value may or may not be recovered over time. We continue to monitor the fair value of our entire securities portfolio as part of our ongoing other than temporary impairment ( OTTI ) evaluation process. No assurance can be given that we will not need to recognize OTTI charges related to securities in the future. In addition, as a condition to membership in the Federal Home Loan Bank of Dallas ( FHLB-Dallas ), we are required to purchase and hold a certain amount of FHLB-Dallas stock. Our stock purchase requirement is based, in part, upon the outstanding principal balance of advances from the FHLB-Dallas. At September 30, 2009, we had stock in the FHLB-Dallas totaling $562,000. The FHLB-Dallas stock held by us is carried at cost and is subject to recoverability testing under applicable accounting standards. For the nine months ended September 30, 2009, we did not recognize an impairment charge related to our FHLB-Dallas stock holdings. There can be no assurance, however, that future negative changes to the financial condition of the FHLB-Dallas may not require us to recognize an impairment charge with respect to such holdings. We rely heavily on our management team and the loss of key officers may adversely affect operations. Our success has been and will continue to be greatly influenced by the ability to retain existing senior management and, with expansion, to attract and retain qualified additional senior and middle management. C.R. Cloutier, President and Chief Executive Officer, and other executive officers have been instrumental in developing and managing our business. We recently had a number of changes in our senior management team, including the appointment of a new Chief Financial Officer, the resignation of the head of the retail division of the Bank and the medical leave of absence of our Chief Operating Officer. The loss of the services of these individuals, or future unexpected loss of services of Mr. Cloutier or any other current executive could have an adverse effect on the Company. We do not have an employment agreement with Mr. Cloutier and a formal management succession plan has not been established. No assurance can be provided that we will be able to locate and hire a qualified replacement for any of the recently departed officers or otherwise on a timely basis. Table of Contents Our participation in the TARP Transaction could also have an adverse effect on our ability to attract and retain qualified executive officers. The American Recovery and Reinvestment Act of 2009 included amendments to the executive compensation provisions of the EESA under which the Treasury s CPP was established, including extensive new restrictions on our ability to pay retention awards, bonuses and other incentive compensation during the period in which we have any outstanding securities held by the Treasury that were issued in the TARP Transaction. Many of the restrictions are not limited to our senior executives and cover other employees whose contributions to revenue and performance can be significant. The limitations may adversely affect our ability to recruit and retain these key employees in addition to our senior executive officers, especially if we are competing for talent against institutions that are not subject to the same CPP restrictions. The Federal Reserve, and perhaps the FDIC, are contemplating proposed rules governing the compensation practices of financial institutions and these rules, if adopted, may adversely affect our management retention and limit our ability to promote our objectives through our compensation and incentive programs and, as a result, adversely affect our results of operations and financial position. The full scope and impact of these limitations are uncertain and difficult to predict. The Secretary of the Treasury has adopted standards that implement certain compensation limitations, but these standards have not yet been broadly interpreted and remain, in many respects, ambiguous. The new and potential future legal requirements and implementing standards under the CPP may have unforeseen or unintended adverse effects on the financial services industry as a whole, and particularly on CPP participants, including us. It will likely require significant time, effort and resources on our part to interpret and apply them. If any of our regulators believe that our response to new and future legal requirements and implementing standards does not fully comply with them, it could subject us to regulatory actions or otherwise adversely affect our management retention and, as a result, our results of operations and financial condition. Even if we redeem our Series A Preferred Stock and repurchase the warrant that we issued to the Treasury, we will continue to be subject to evolving legal and regulatory requirements that may, among other things, require increasing amounts of our time, effort and resources to ensure compliance. A natural disaster, especially one affecting one of our market areas, could adversely affect us. Since most of our business is conducted in Louisiana and Texas, most of our credit exposure is in those states. Historically, Louisiana and Texas have been vulnerable to natural disasters. Therefore, we are susceptible to the risks of natural disasters, such as hurricanes, floods and tornados. Natural disasters could harm our operations directly through interference with communications, including the interruption or loss of our websites, which would prevent us from gathering deposits, originating loans and processing and controlling our flow of business, as well as through the destruction of facilities and our operational, financial and management information systems. A natural disaster or recurring power outages may also impair the value of our largest class of assets, our loan portfolio, as uninsured or underinsured losses, including losses from business disruption, may reduce borrowers ability to repay their loans. Disasters may also reduce the value of the real estate securing our loans, impairing our ability to recover on defaulted loans through foreclosure and making it more likely that we would suffer losses on defaulted loans. Although we have implemented several back-up systems and protections (and maintain business interruption insurance), these measures may not protect us fully from the effects of a natural disaster. The occurrence of natural disasters in our market areas could have a material adverse effect on our business, prospects, financial condition and results of operations. Our profitability is vulnerable to interest rate fluctuations. Our profitability is dependent to a large extent on net interest income, which is the difference between our interest income on interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Conversely, when interest-earning assets mature or reprice more quickly Table of Contents than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income. For example, as securities in our investment portfolio have matured, they have been replaced by securities paying a lower yield. We expect this trend to continue into 2010. These changes in our investment portfolio have negatively impacted, and are expected to continue to negatively impact, our net interest margin. Furthermore, some of our variable interest rate loans have minimum fixed interest rates ( floors ) that are currently above the contractual variable interest rate. If interest rates rise, the interest income from our variable interest rate loans with floors may not increase as quickly as interest expense on our liabilities, which would negatively impact our net interest income. In periods of increasing interest rates, loan originations may decline, depending on the performance of the overall economy, which may adversely affect income from lending activities. Also, increases in interest rates could adversely affect the market value of fixed income assets. In addition, an increase in the general level of interest rates may affect the ability of certain borrowers to pay the interest and principal on their obligations. Non-performing assets take significant time to resolve and adversely affect our results of operations and financial condition. Non-performing assets adversely affect our net earnings in various ways. Until economic and market conditions improve, we expect to continue to incur provisions for loan losses relating to an increase in non-performing assets. We generally do not record interest income on non-performing loans or other real estate owned, thereby adversely affecting our earnings, and increasing our loan administration costs. When we take collateral in foreclosures and similar proceedings, we are required to mark the related asset to the then fair market value of the collateral, which may ultimately result in a loss. An increase in the level of non-performing assets increases our risk profile and may impact the capital levels our regulators believe are appropriate in light of the ensuing risk profile. While we reduce problem assets through loan sales, workouts, restructurings and otherwise, decreases in the value of the underlying collateral, or in these borrowers performance or financial condition, whether or not due to economic and market conditions beyond our control, could adversely affect our business, results of operations and financial condition. In addition, the resolution of non-performing assets requires significant commitments of time from management and our directors, which can be detrimental to the performance of their other responsibilities. There can be no assurance that we will not experience future increases in non-performing assets. The soundness of other financial institutions could negatively affect us. Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to us. Any such losses could have a material adverse effect on our business, prospects, financial condition and results of operations. Higher FDIC deposit insurance premiums and assessments could adversely affect our financial condition. FDIC insurance premiums increased substantially in 2009, and we expect to pay significantly higher FDIC premiums in the future. As the large number of recent bank failures continues to deplete the Deposit Insurance Fund, the FDIC adopted a revised risk-based deposit insurance assessment schedule in February 2009, which raised deposit insurance premiums. The FDIC also implemented a five basis point special assessment of each insured depository institution s assets minus Tier 1 capital as of June 30, 2009, which special assessment amount was capped at 10 basis points times the institution s assessment base for the second quarter of 2009. The amount of our special assessment was approximately $416,000. In addition, the FDIC recently announced a proposed rule that will require financial institutions, such as MidSouth Bank, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010 through and including 2012 in order to re-capitalize the Deposit Insurance Fund. The proposed rule also provides for increasing the FDIC-assessment rates by three basis points effective January 1, 2011. The amount of our prepayment is expected to be approximately $4.7 million. Table of Contents We operate within a highly regulated industry and our business and results are significantly affected by the regulations to which we are subject. We operate within a highly regulated environment. The regulations to which we are subject will continue to have a significant impact on our operations and the degree to which we can grow and be profitable. Certain regulators, to which we are subject, have significant power in reviewing our operations and approving our business practices. In recent years the Bank, as well as other financial institutions, has experienced increased regulation and regulatory scrutiny, often requiring additional resources. In addition, investigations or proceedings brought by regulatory agencies may result in judgments, settlements, fines, penalties, or other results adverse to us. There is no assurance that any change to the regulatory requirements to which we are subject, or the way in which such regulatory requirements are interpreted or enforced, will not have a negative effect on our ability to conduct our business and our results of operations. We rely heavily on technology and computer systems. The negative effects of computer system failures and unethical individuals with the technological ability to cause disruption of service could significantly affect our reputation and our ability to generate deposits. Our ability to compete depends on our ability to continue to adapt and deliver technology on a timely and cost-effective basis to meet customers demands for financial services. We currently provide our customers the ability to bank online and many customers now remotely submit deposits to us through remote-capture systems. The secure transmission of confidential information over the Internet is a critical element of these services. Our network could be vulnerable to unauthorized access, computer viruses, phishing schemes and other security problems. We may be required to spend significant capital and other resources to protect against the threat of security breaches and computer viruses, or to alleviate problems caused by security breaches or viruses. To the extent that our activities or the activities of our customers involve the storage and transmission of confidential information, security breaches and viruses could expose us to claims, litigation and other possible liabilities. Any inability to prevent security breaches or computer viruses could also cause existing customers to lose confidence in our systems and could adversely affect our reputation and our ability to generate deposits. Risks Relating to an Investment in Our Common Stock Share ownership may be diluted by the issuance of additional shares of common stock in the future. Our stock incentive plan provides for the granting of stock incentives to directors, officers, and employees. As of September 30, 2009, there were 61,368 shares issued under options granted under that plan. Likewise, subject to the availability of shares of our common stock, up to approximately 585,000 shares, including shares issuable under currently outstanding options, may be issued in the future to directors, officers, and employees under our existing equity incentive plans. In addition, on January 9, 2009, the Company issued $20.0 million in preferred stock to the Treasury in the TARP Transaction. As part of the TARP Transaction we have also granted the Treasury a 10-year warrant to purchase 208,768 shares of our common stock at an exercise price of $14.37 per share. It is probable that options and or/warrants will be exercised during their respective terms if the stock price exceeds the exercise price of the particular option or warrant. The incentive plan also provides that all issued options automatically and fully vest upon a change in control. If the options are exercised, share ownership will be diluted. In addition, our articles of incorporation authorize the issuance of up to 10,000,000 shares of common stock and 5,000,000 shares of preferred stock, but do not provide for preemptive rights to the shareholders and, therefore, shareholders will not automatically have the right to subscribe for additional shares. As a result, if we issue additional shares after this offering to raise additional capital or for other corporate purposes, you may be unable to maintain a pro rata ownership in the Company. We may seek to amend our articles of incorporation in the future to increase the number of shares of stock that we are authorized to issue. Any such amendment would require approval by an affirmative vote of the holders of a majority of the shares present and entitled to vote at such meeting. There can be no assurance that we will seek such an amendment or, if such an amendment is submitted to a vote of our shareholders, that it would be approved by our shareholders. Table of Contents The holders of our preferred stock and trust preferred securities have rights that are senior to those of shareholders and that may impact our ability to pay dividends on our common stock and with net income available to our common shareholders. At September 30, 2009, we had outstanding $15.5 million of trust preferred securities. These securities are senior to shares of common stock. As a result, we must make payments on our trust preferred securities before any dividends can be paid on our common stock; moreover, in the event of our bankruptcy, dissolution, or liquidation, the obligations outstanding with respect to our trust preferred securities must be satisfied before any distributions can be made to our shareholders. While we have the right to defer dividends on the trust preferred securities for a period of up to five years, if any such election is made, no dividends may be paid to our common or preferred shareholders during that time. In addition, with respect to the $20.0 million in Series A Preferred Stock outstanding that was issued to the Treasury in the TARP Transaction, we are required to pay cumulative dividends on the Series A Preferred Stock at an annual rate of 5.0% for the first five years and 9.0% thereafter, unless we redeem the shares earlier. Dividends paid on our Series A Preferred Stock will also reduce the net income available to our common shareholders and our earnings per common share. We may not declare or pay dividends on our common stock or repurchase shares of our common stock without first having paid all accrued cumulative preferred dividends that are due. Until January 2012, we also may not increase our per share common stock dividend rate or repurchase shares of our common shares without the Treasury s consent, unless the Treasury has transferred to third parties all the Series A Preferred Stock originally issued to it. There can be no assurance whether or when the Series A Preferred Stock can be redeemed or whether or when the related warrant can be repurchased. Subject to approval of our regulators, we generally have the right to repurchase the shares of Series A Preferred Stock and the associated warrant issued to the Treasury in the TARP Transaction. However, there can be no assurance as to when the Series A Preferred Stock and the warrant will be repurchased, if at all. As a result, we will remain subject to the uncertainty of additional future changes to the CPP, which could put us at a competitive disadvantage. Until such time as the Series A Preferred Stock and the warrant are repurchased, we will remain subject to the terms and conditions of those instruments, which, among other things, require us to obtain regulatory approval to repurchase or redeem our common stock or our other preferred stock or increase the annual aggregate dividends on our common stock over $0.28 per share, except in limited circumstances. Holders of the Series A Preferred Stock may, under certain circumstances, have the right to elect two directors to our board of directors. In the event that we fail to pay dividends on the Series A Preferred Stock for an aggregate of six quarterly dividend periods or more, the authorized number of directors then constituting our board of directors will be increased by two. Holders of the Series A Preferred Stock, together with the holders of any outstanding parity stock with the same voting rights, will be entitled to elect the two additional members of the board of directors at the next annual meeting (or at a special meeting called for this purpose) and at each subsequent annual meeting until all accrued and unpaid dividends for all past dividend periods have been paid in full. Only a limited trading market exists for our common stock, which could lead to price volatility. Our common stock is listed for trading on the NYSE Amex under the trading symbol MSL, but there is low trading volume in our common stock. The limited trading market for our common stock may cause fluctuations in the market value of our common stock to be exaggerated, leading to price volatility in excess of that which might occur in a more active trading market of our common stock. Future sales of substantial amounts of common stock in the public market, or the perception that such sales may occur, could adversely affect the Table of Contents prevailing market price of our common stock. In addition, even if a more active market in our common stock develops, we cannot assure you that such a market will continue or that shareholders will be able to sell their shares at or above the price offered by this prospectus. Our directors and executive management own a significant number of shares of stock, allowing further control over business and corporate affairs. Our directors and executive officers beneficially own approximately 2,178,000 shares, or 32.9%, of our outstanding common stock as of September 30, 2009. As a result, in addition to their day-to-day management roles, they will be able to exercise significant influence on our business as shareholders, including influence over election of the Board and the authorization of other corporate actions requiring shareholder approval. In deciding on how to vote on certain proposals, our shareholders should be aware that our directors and executive officers may have interests that are different from, or in addition to, the interests of our shareholders generally. We have broad discretion in using/applying the net proceeds from this offering and could be adversely affected if we fail to use the funds effectively. We intend to use the net proceeds from this offering for general corporate purposes, including the contribution of a portion of the proceeds to the Bank as additional capital. The net proceeds would also support future growth, which may include accelerated organic growth in our existing markets and opportunistic acquisitions of all or part of other financial institutions, potentially including FDIC-assisted transactions. We will have significant flexibility in applying the net proceeds of this offering. Our failure to apply these funds effectively could adversely affect our business by reducing our return on equity and inhibiting our abilities to expand and/or raise additional capital in the future. Provisions of our articles of incorporation and by-laws, Louisiana law, and state and federal banking regulations, could delay or prevent a takeover by a third party. Our articles of incorporation and by-laws could delay, defer, or prevent a third party takeover, despite possible benefit to the shareholders, or otherwise adversely affect the price of our common stock. Our governing documents: permit directors to be removed by shareholders only for cause and only upon an 80% vote; require 80% of the voting power for shareholders to amend the by-laws, call a special meeting, or amend the articles of incorporation, in each case if the proposed action was not approved by the Board; authorize a class of preferred stock that may be issued in series with terms, including voting rights, established by the Board without shareholder approval; authorize approximately 10 million shares of common stock and 5 million shares of preferred stock that may be issued by the Board without shareholder approval; classify our Board with staggered three year terms, preventing a change in a majority of the Board at any annual meeting; require advance notice of proposed nominations for election to the Board and business to be conducted at a shareholder meeting; and require 80% of the voting power for shareholders to approve business combinations not approved by the Board. These provisions would likely preclude a third party from removing incumbent directors and simultaneously gaining control of the Board by filling the vacancies thus created with its own nominees. Under the classified Board provisions, it would take at least two elections of directors for any individual or group to gain control of the Board. Accordingly, these provisions could discourage a third party from initiating a proxy contest, making a Table of Contents tender offer or otherwise attempting to gain control. These provisions may have the effect of delaying consideration of a shareholder proposal until the next annual meeting unless a special meeting is called by the Board or the chairman of the Board. Moreover, even in the absence of an attempted takeover, the provisions make it difficult for shareholders dissatisfied with the Board to effect a change in the Board s composition, even at annual meetings. Also, we are subject to the provisions of the Louisiana Business Corporation Law ( LBCL ), which provides that we may not engage in certain business combinations with an interested shareholder (generally defined as the holder of 10.0% or more of the voting shares) unless (1) the transaction was approved by the Board before the interested shareholder became an interested shareholder or (2) the transaction was approved by at least two-thirds of the outstanding voting shares not beneficially owned by the interested shareholder and 80% of the total voting power or (3) certain conditions relating to the price to be paid to the shareholders are met. The LBCL also addresses certain transactions involving control shares, which are shares that would have voting power with respect to the Company within certain ranges of voting power. Control shares acquired in a control share acquisition have voting rights only to the extent granted by a resolution approved by our shareholders. If control shares are accorded full voting rights and the acquiring person has acquired control shares with a majority or more of all voting power, shareholders of the issuing public corporation have dissenters rights as provided by the LBCL. A holder with as little as a 5% interest in MidSouth could, under certain circumstances, be subject to regulation as a bank holding company. Any entity (including a group composed of natural persons) owning 25% or more of our outstanding common stock, or 5% or more if such holder otherwise exercises a controlling influence over us, may be subject to regulation as a bank holding company in accordance with the Bank Holding Company Act of 1956, as amended, or the BHCA. In addition, (1) any bank holding company or foreign bank with a U.S. presence may be required to obtain the approval of the Federal Reserve Board under the BHCA to acquire or retain 5% or more of our outstanding common stock and (2) any person other than a bank holding company may be required to obtain regulatory approval under the Change in Bank Control Act of 1978, as amended, to acquire or retain 10% or more of our outstanding common stock. Becoming a bank holding company imposes certain statutory and regulatory restrictions and burdens, and might require the holder to divest all or a portion of the holder s investment in our common stock. In addition, because a bank holding company is required to provide managerial and financial strength for its bank subsidiary, such a holder may be required to divest investments that may be deemed incompatible with bank holding company status, such as a material investment in a company unrelated to banking. Our future ability to pay dividends and repurchase stock is subject to restrictions. Since we are a holding company with no significant assets other than the Bank, we have no material source of income other than dividends received from the Bank. Therefore, our ability to pay dividends to our shareholders will depend on the Bank s ability to pay dividends to us. Moreover, banks and bank holding companies are both subject to certain federal and state regulatory restrictions on cash dividends. We are also restricted from paying dividends if we have deferred payments of the interest on, or an event of default has occurred with respect to, our trust preferred securities or Series A Preferred Stock. Additionally, terms and conditions of our outstanding shares of preferred stock place certain restrictions and limitations on our common stock dividends and repurchases of our common stock. See Dividend Policy. A shareholder s investment is not an insured deposit. An investment in our common stock is not a bank deposit and is not insured or guaranteed by the FDIC or any other government agency. Your investment in our common stock will be subject to investment risk and you may lose all or part of your investment. Table of Contents

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+conditions in relevant financial markets in the United States, the PRC and elsewhere in the world. We may not be able to effectively control and manage our growth. If our business and markets grow and develop, it will be necessary for us to finance and manage expansion in an orderly fashion. We may face challenges in managing our industrial waste treatment and disposal business over an expanded geographical area as well as managing a business offering expanded waste treatment services. We may also encounter difficulties in integrating acquired businesses with our own. Such eventualities will increase demands on our existing management, workforce and facilities. Failure to satisfy such increased demands could interrupt or adversely affect our operations and cause administrative inefficiencies. If we are unable to successfully complete and integrate new operational locations in a timely manner, our growth strategy could be adversely impacted. An important element of our growth strategy is expected to be the development of operational locations outside of Dalian, China. However, integrating businesses involves a number of special risks, including the possibility that management may be distracted from regular business concerns by the need to integrate operations, unforeseen difficulties in integrating operations and systems, problems relating to assimilating and retaining the employees of acquired businesses, accounting issues that arise in connection with acquisitions, challenges in retaining customers, and potential adverse short-term effects on operating results. In addition, we may incur debt to finance future operational locations, and we may issue securities in connection with future operational locations that may dilute the holdings of our current or future stockholders. If we are unable to successfully complete and integrate new operational locations in a timely manner, our business, growth strategy and financial results could be materially and adversely impacted. Our waste treatment operations are risky and we may be subject to civil liabilities as a result of hazards posed by such operations, and our insurance coverage may not be sufficient to cover our exposure. Our operations are subject to potential hazards incident to the gathering, processing and storage of industrial waste such as explosions, product spills, leaks, emissions and fires. These hazards can cause personal injury and loss of life, severe damage to and destruction of property and equipment, and pollution or other environmental damage, and may result in curtailment or suspension of operations at the affected facility. Consequently, we may face civil liabilities in the ordinary course of our business. While we currently maintain liability insurance to protect against certain of these liabilities, the extent of our insurance coverage may not be sufficient to cover all possible liabilities. Although we have not faced any civil liabilities historically in the ordinary course of our waste treatment operations, there is no assurance that we will not face such liabilities in the future. If such liabilities occur in the future, they may adversely and materially affect our operations and financial condition. Failure to retain services of key personnel will affect our operations and results. Our success to date has been largely due to the contributions of our executive officers. The continued success of our business is very much dependent on the goodwill that they have developed in the industry over the past years. Our continued success is dependent, to a large extent, on our ability to retain the services of our executive officers. The loss of any of our executive officers services due to resignation, retirement, illness or otherwise without suitable replacement or the inability to attract and retain qualified personnel would affect our operations and may reduce our profitability and the return on your investment. We do not currently maintain key man insurance covering our executive officers. We may not be able to protect our processes, technologies and systems against claims by other parties. Although we have four registered PRC patents and have applied for two other PRC patents in respect of the processes, technologies and systems we use frequently in our systems, we have not purchased or applied for any patents other than these as we are of the view that it may not be cost-effective to do so. For such other processes, technologies and systems for which we have not applied for or purchased or been licensed to use patents, we may have no legal recourse to protect our rights in the event that they are replicated by other parties. If our competitors are able to replicate our processes, technologies and systems at lower costs, we may lose our competitive edge and our profitability may be reduced. We may face claims for infringement of third-party intellectual property rights. We may face claims from third parties in respect of the infringement of any intellectual property rights owned by such third parties. There is no assurance that third parties will not assert claims to our processes, technologies and systems. In such an event, we may need to acquire licenses to, or to contest the validity of, issued or pending patents or claims of third parties. There can be no assurance that any license acquired under such patents would be made available to us on acceptable terms, if at all, or that we would prevail in any such contest. In addition, we would incur substantial costs and spend substantial amounts of time in defending ourselves in or contesting suits brought against us for alleged infringement of another party s patent rights. As such, our operations and business may be adversely affected by such civil actions. We rely on trade secrets, technology and know-how. There can be no assurance that other parties may not obtain knowledge of our trade secrets and processes, technology and systems. Should these events occur, our business would be affected and our profitability reduced. We are reliant on a few major suppliers. We are dependent on our major suppliers for the timely delivery of waste materials that we require for our recycling operations. Should our major suppliers fail to deliver such materials on time, and if we are unable to source these materials from alternative suppliers on a timely basis, our revenue and profitability could be adversely affected. We are subject to risks relating to BOT (Build-Operate-Transfer) projects in which we have started to invest. Our 90% owned subsidiary, Dongtai, has begun to invest capital in BOT projects which require high up-front capital expenditures. For example, Dongtai has entered into agreements to invest in Dongtai Water Recycling Company, which is constructing and will operate a municipal sewage treatment facility in Dalian, China and Dongtai Organic Waste Treatment Company, which is constructing and will operate a sludge treatment and disposal facility in Dalian, China. Our returns from BOT projects are derived from fees paid by the PRC government and such BOT projects are able to generate a steady and recurring source of income for us over a sustained period of time between 20 and 25 years. However, our BOT projects are exposed to risks such as the occurrence of natural disasters or the imposition of more stringent government regulations, which may result in the disruption of our BOT projects. Our investment returns from these BOT projects may thus be reduced should any of such risks materialize. In addition, our lack of experience in administering BOT projects may negatively impact our ability to successfully manage the projects we have undertaken. Risks Related to Doing Business in the PRC We face the risk that changes in the policies of the PRC government could have a significant impact upon the business we may be able to conduct in the PRC and the profitability of such business. The PRC s economy is in a transition from a central planned economy to a market oriented economy subject to five-year and annual plans adopted by the government that set national economic development goals. Policies of the PRC government can have significant effects on the economic conditions of the PRC. The PRC government has confirmed that economic development will follow the model of a market economy. Under this direction, we believe that the PRC will continue to strengthen its economic and trading relationships with foreign countries and business development in the PRC will follow market forces. While we believe that this trend will continue, we cannot assure you that this will be the case. A change in policies by the PRC government could adversely affect our interests by, among other factors: changes in laws, regulations or the interpretation thereof, confiscatory taxation, restrictions on currency conversion, imports or sources of supplies, or the expropriation or nationalization of private enterprises. Although the PRC government has been pursuing economic reform policies for more than two decades, we cannot assure you that the government will continue to pursue such policies or that such policies may not be significantly altered, especially in the event of a change in leadership, social or political disruption, or other circumstances affecting the PRC's political, economic and social life. Introduction of new laws or changes to existing laws by the PRC government may adversely affect our business. The PRC legal system is a codified legal system made up of written laws, regulations, circulars, administrative directives and internal guidelines. Unlike common law jurisdictions like the U.S., decided cases (which may be taken as reference) do not form part of the legal structure of the PRC and thus have no binding effect. Furthermore, in line with its transformation from a centrally-planned economy to a more free market-oriented economy, the PRC government is still in the process of developing a comprehensive set of laws and regulations. As the legal system in the PRC is still evolving, laws and regulations or the interpretation of the same may be subject to further changes. For example, the PRC government may impose restrictions on the amount of tariff that may be payable by municipal governments to waste water treatment service providers like us. Also, more stringent environmental regulations may also affect our ability to comply with, or our costs to comply with, such regulations. Such changes, if implemented, may adversely affect our business operations and may reduce our profitability. The PRC laws and regulations governing our current business operations are sometimes vague and uncertain. Any changes in such PRC laws and regulations may have a material and adverse effect on our business. There are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including, but not limited to, the laws and regulations governing our business, or the enforcement and performance of our arrangements with customers in the event of the imposition of statutory liens, death, bankruptcy and criminal proceedings. We and any future subsidiaries are considered foreign persons or foreign funded enterprises under PRC laws, and as a result, we are required to comply with PRC laws and regulations. These laws and regulations are sometimes vague and may be subject to future changes, and their official interpretation and enforcement may involve substantial uncertainty. The effectiveness of newly enacted laws, regulations or amendments may be delayed, resulting in detrimental reliance by foreign investors. New laws and regulations that affect existing and proposed future businesses may also be applied retroactively. We cannot predict what effect the interpretation of existing or new PRC laws or regulations may have on our businesses. A slowdown or other adverse developments in the PRC economy may materially and adversely affect our customers, demand for our services and our business. We are a holding company. All of our operations are conducted in the PRC and all of our revenues are generated from sales in the PRC. Although the PRC economy has grown significantly in recent years, we cannot assure you that such growth will continue. The industrial waste treatment industry in the PRC is relatively new and growing, but we do not know how sensitive we are to a slowdown in economic growth or other adverse changes in the PRC economy which may affect demand for our services. A slowdown in overall economic growth, an economic downturn or recession or other adverse economic developments in the PRC may materially reduce the demand for our services and the recycled materials we sell and materially and adversely affect our business. Inflation in the PRC could negatively affect our profitability and growth. While the PRC economy has experienced rapid growth, such growth has been uneven among various sectors of the economy and in different geographical areas of the country. Rapid economic growth can lead to growth in the money supply and rising inflation. If prices for our products rise at a rate that is insufficient to compensate for the rise in the costs of supplies, it may have an adverse effect on profitability. In order to control inflation in the past, the PRC government has imposed controls on bank credits, limits on loans for fixed assets and restrictions on state bank lending. Such an austere policy can lead to a slowing of economic growth. In October 2004, the People s Bank of China, the PRC s central bank, raised interest rates for the first time in nearly a decade and indicated in a statement that the measure was prompted by inflationary concerns in the Chinese economy. Repeated rises in interest rates by the central bank would likely slow economic activity in China which could, in turn, materially increase our costs and also reduce demand for our services and recycled products. Our PRC subsidiaries are subject to restrictions on paying dividends and making other payments to us. We are a holding company incorporated in the State of Nevada and do not have any assets or conduct any business operations other than our investments in our subsidiaries in China. As a result of our holding company structure, we rely primarily on dividend payments from our subsidiaries. However, PRC regulations currently permit payment of dividends only out of accumulated profits, as determined in accordance with PRC accounting standards and regulations. Our subsidiaries in China are also required to set aside a portion of their after-tax profits according to PRC accounting standards and regulations to fund certain reserve funds. The PRC government also imposes controls on the conversion of RMB into foreign currencies and the remittance of currencies out of China. We may experience difficulties in completing the administrative procedures necessary to obtain and remit foreign currency. Furthermore, if our subsidiaries in China incur debt on their own in the future, the instruments governing the debt may restrict its ability to pay dividends or make other payments. If we or our subsidiaries are unable to receive all of the revenues from our operations through these contractual or dividend arrangements, we may be unable to pay dividends on our common stock. Governmental control of currency conversion may affect the value of your investment. The PRC government imposes controls on the convertibility of Renminbi into foreign currencies and, in certain cases, the remittance of currency out of the PRC. We receive substantially all of our revenues in Renminbi, which is currently not a freely convertible currency. Shortages in the availability of foreign currency may restrict our ability to remit sufficient foreign currency to pay dividends, or otherwise satisfy foreign currency dominated obligations. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and expenditures from the transaction, can be made in foreign currencies without prior approval from the PRC State Administration of Foreign Exchange by complying with certain procedural requirements. However, approval from appropriate governmental authorities is required where Renminbi is to be converted into foreign currency and remitted out of the PRC to pay capital expenses such as the repayment of bank loans denominated in foreign currencies. The PRC government may also at its discretion restrict access in the future to foreign currencies for current account transactions. If the foreign exchange control system prevents us from obtaining sufficient foreign currency to satisfy our currency demands, we may not be able to pay certain of our expenses as they come due. The fluctuation of the Renminbi may materially and adversely affect your investment. The value of the Renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in the PRC's political and economic conditions. As we rely entirely on revenues earned in the PRC, any significant revaluation of the Renminbi may materially and adversely affect our cash flows, revenues and financial condition. For example, to the extent that we need to convert U.S. dollars we receive from an offering of our securities into Renminbi for our operations, appreciation of the Renminbi against the U.S. dollar could have a material adverse effect on our business, financial condition and results of operations. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of making payments for dividends on our common shares or for other business purposes and the U.S. dollar appreciates against the Renminbi, the U.S. dollar equivalent of the Renminbi we convert would be reduced. In addition, the depreciation of significant U.S. dollar denominated assets could result in a charge to our income statement and a reduction in the value of these assets. On July 21, 2005, the PRC government changed its decade-old policy pegging the value of the RMB to the U.S. dollar. Under the new policy, the RMB is permitted to fluctuate within a narrow and managed band against a basket of certain foreign currencies. This change in policy has resulted in an approximately 11.8% appreciation of the RMB against the U.S. dollar. While the international reaction to the RMB revaluation has generally been positive, there remains significant international pressure on the PRC government to adopt an even more flexible currency policy, which could result in a further and more significant appreciation of the RMB against the U.S. dollar. Recent PRC State Administration of Foreign Exchange ( SAFE ) Regulations regarding offshore financing activities by PRC residents, have undertaken continuous changes which may increase the administrative burden we face and create regulatory uncertainties that could adversely affect the implementation of our acquisition strategy, and a failure by our stockholders who are PRC residents to make any required applications and filings pursuant to such regulations may prevent us from being able to distribute profits and could expose us and our PRC resident stockholders to liability under PRC law. Recent regulations promulgated by the PRC State Administration of Foreign Exchange, or SAFE, regarding offshore financing activities by PRC residents have undergone a number of changes which may increase the administrative burden we face. The failure by our stockholders who are PRC residents to make any required applications and filings pursuant to such regulations may prevent us from being able to distribute profits and could expose us and our PRC resident stockholders to liability under PRC law. In 2005, SAFE promulgated regulations in the form of public notices, which require registrations with, and approval from, SAFE on direct or indirect offshore investment activities by PRC resident individuals. The SAFE regulations require that if an offshore company directly or indirectly formed by or controlled by PRC resident individuals, known as SPC, intends to acquire a PRC company, such acquisition will be subject to strict examination by the SAFE. Without registration, the PRC entity cannot remit any of its profits out of the PRC as dividends or otherwise. Any recurrence of severe acute respiratory syndrome, or SARS, or another widespread public health problem, could adversely affect our operations. A renewed outbreak of SARS or another widespread public health problem in the PRC, where all of the Company s revenue is derived, could have an adverse effect on our operations. Our operations may be impacted by a number of health-related factors, including quarantines or closures of some of our facilities or offices that would adversely disrupt our operations. Any of the foregoing events or other unforeseen consequences of public health problems could adversely affect our operations. Because our principal assets are located outside of the United States and all of our directors and all our officers reside outside of the United States, it may be difficult for you to enforce your rights based on U.S. Federal Securities Laws against us and our officers and directors or to enforce a judgment of a United States court against us or our officers and directors in the PRC. All of our directors and officers reside outside of the United States. In addition, our operating subsidiary is located in the PRC and substantially all of our assets are located outside of the United States. It may therefore be difficult for investors in the United States to enforce their legal rights based on the civil liability provisions of the U.S. Federal securities laws against us in the courts of either the U.S. or the PRC and, even if civil judgments are obtained in U.S. courts, to enforce such judgments in PRC courts. Further, it is unclear if extradition treaties now in effect between the United States and the PRC would permit effective enforcement against us or our officers and directors of criminal penalties, under the U.S. Federal securities laws or otherwise. Restrictions on currency exchange may limit our ability to receive and use our revenues effectively. Because all of our revenues are in the form of RMB, any future restrictions on currency exchanges may limit our ability to use revenue generated in RMB to fund any future business activities outside China or to make dividend or other payments in U.S. dollars. Although the Chinese government introduced regulations in 1996 to allow greater convertibility of the RMB for current account transactions, significant restrictions still remain, including primarily the restriction that foreign-invested enterprises may only buy, sell or remit foreign currencies, after providing valid commercial documents, at those banks authorized to conduct foreign exchange business. In addition, conversion of RMB for capital account items, including direct investment and loans, is subject to government approval in China, and companies are required to open and maintain separate foreign exchange accounts for capital account items. We cannot be certain that the Chinese regulatory authorities will not impose more stringent restrictions on the convertibility of the RMB, especially with respect to foreign exchange transactions. A slowdown in the Chinese economy or an increase in its inflation rate may adversely impact our revenues. The Chinese economy has grown at an approximately 9% rate for more than 25 years, making it one of the fastest growing major economy in recorded history. In 2007, China s economy grew by 11.4%, the fastest pace in 11 years. While China s economy has grown, inflation has also recently become a major issue of concern. In March 2007, China s central bank, the People s Bank of China, announced that the bank reserve ratio would rise half a percentage point to 15.5% in an effort to reduce inflation soon after Premier Wen Jiabao highlighted inflation as a major concern for the government. China s consumer price index growth rate reached 8.7% year over year in 2008. We cannot assure you that growth of the Chinese economy will be steady, that inflation will be controllable or that any slowdown in the economy or uncontrolled inflation will not have a negative effect on our business. Several years ago, the Chinese economy experienced deflation, which may recur in the future. More recently, the Chinese government announced its intention to continuously use macroeconomic tools and regulations to slow the rate of growth of the Chinese economy, the results of which are difficult to predict. We may face obstacles from the communist system in the PRC. Foreign companies conducting operations in PRC face significant political, economic and legal risks. The Communist regime in the PRC, including a cumbersome bureaucracy, may hinder Western investment. We may have difficulty establishing adequate management, legal and financial controls in the PRC. The PRC historically has not adopted a western style of management and financial reporting concepts and practices, as well as in modern banking, computer and other control systems. We may have difficulty in hiring and retaining a sufficient number of qualified employees to work in the PRC. As a result of these factors, we may experience difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet Western standards. Risks Related to Our Common Stock Our officers, directors and affiliates control us through their positions and stock ownership and their interests may differ from other stockholders. Our officers, directors and affiliates beneficially own approximately 69% of our outstanding common stock of CIWT. Dong Jinqing, our Chairman, President and Chief Executive Officer, beneficially owns 9,847,900 shares (approximately 65%) of our outstanding common stock. As a result, Mr. Dong is and will continue to be able to influence the outcome of stockholder votes on various matters, including the election of directors and extraordinary corporation transactions including business combinations. Mr. Dong s interests may differ from other stockholders. Additional information relating to the beneficial ownership of our securities is contained elsewhere in this report under Security Ownership of Certain Beneficial Owners and Management. We are not likely to pay cash dividends in the foreseeable future. We currently intend to retain any future earnings for use in the operation and expansion of our business. We do not expect to pay any cash dividends in the foreseeable future, but will review this policy as circumstances dictate. Should we decide in the future to do so, as a holding company, our ability to pay dividends and meet other obligations depends upon the receipt of dividends or other payments from our operating subsidiary. In addition, our operating subsidiary, from time to time, may be subject to restrictions on its ability to make distributions to us, including as a result of restrictions on the conversion of local currency into U.S. dollars or other hard currency and other regulatory restrictions. Our common stock is illiquid and subject to price volatility unrelated to our operations. The market price of our common stock could fluctuate substantially due to a variety of factors, including market perception of our ability to achieve our planned growth, quarterly operating results of other companies in the same industry, trading volume in our common stock, changes in general conditions in the economy and the financial markets or other developments affecting our competitors or us. In addition, the stock market is subject to extreme price and volume fluctuations. This volatility has had a significant effect on the market price of securities issued by many companies for reasons unrelated to their operating performance and could have the same effect on our common stock. We have not voluntarily implemented various corporate governance measures, in the absence of which, stockholders may have more limited protections against interested director transactions, conflicts of interest and similar matters. Recent Federal legislation, including the Sarbanes-Oxley Act of 2002, has resulted in the adoption of various corporate governance measures designed to promote the integrity of the corporate management and the securities markets. Some of these measures have been adopted in response to legal requirements. Others have been adopted by companies in response to the requirements of national securities exchanges, such as the NYSE or the NASDAQ Stock Market, on which their securities are listed. Among the corporate governance measures that are required under the rules of national securities exchanges are those that address board of directors' independence, audit committee oversight, and the adoption of a code of ethics. While we have adopted a Code of Business Conduct and Ethics, we have not yet adopted corporate governance measures such as an audit or other independent committees of our Board of Directors. We have entered into agreements with investors in our private offering that require us to establish a board of directors consisting of a majority of independent directors; however, we have not yet done so. If we expand our board membership in future periods to include independent directors, we may seek to establish an audit and other committees of our Board of Directors. It is possible that if we were to adopt some or all of these corporate governance measures, stockholders would benefit from somewhat greater assurances that internal corporate decisions were being made by disinterested directors and that policies had been implemented to define responsible conduct. For example, in the absence of audit, nominating and compensation committees comprised of at least a majority of independent directors, decisions concerning matters such as compensation packages are made by our current executive officers in their capacities as members of the Board of Directors, as is the determination of the persons who will serve as management s slate of director nominees. Prospective investors should bear in mind our current lack of corporate governance measures in formulating their investment decisions. We have material weaknesses in our disclosure controls and procedures and internal control over financial reporting which have lead to a restatement of certain of our financial statements; there is a possibility that our financial statements will contain errors in future periods. Upon completion of an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as well as management's assessment of the effectiveness of our internal control over financial reporting at December 31, 2007, as required by Section 404 of the Sarbanes-Oxley Act of 2002, our management concluded that our internal control over financial reporting was not completely effective. As a result, our financial statements for the year ended December 31, 2006 and the quarter ended March 31, 2007 contained errors that required us to restate those financial statements. The material weakness that we identified is that we had an insufficient familiarity with generally accepted accounting principles in the United States causing us to improperly (a) account for landfill-related asset retirement obligations and consolidation of the results of operations of a subsidiary company, as a result of which we restated our financial statements as of December 31, 2006 and for the year then ended, and as of March 31, 2007 and for the quarter then ended and, (b) record and reconcile various financial statement entries including accounts receivable balances (including allowance for doubtful accounts), other current assets, construction in progress amounts, customer deposits, deferred revenues depreciation and amortization expenses, certain operating expenses and taxes payable, income and interest expense, a loss on investment, related party transactions; and subsidizing amounts; resulting in numerous audit adjustments. While we have sought to rectify our material weakness by broadening our understanding of United States generally accepted accounting principles and by engaging consultants with a sufficient familiarity with these principles that we will correctly account for assets and properly record various financial entries in the future. However, due to the nature of the material weaknesses in our internal control over financial reporting, there is the possibility that material misstatements of our annual or interim financial statements could occur in the future. To the extent that our stock trades below $5.00 per share, our stock may be considered a "penny stock" which can adversely affect its liquidity. Our common stock has from time-to-time traded at less than $5.00 per share, and, therefore, may be considered a "penny stock" under Securities and Exchange Commission rules. Trading in penny stocks is subject to the requirements of Rule 15g-9 under the Securities Exchange Act of 1934. Under this rule, broker/dealers who recommend low-priced securities to persons other than established customers and accredited investors must satisfy special sales practice requirements. The broker/dealer must make an individualized written suitability determination for the purchaser and receive the purchaser's written consent prior to the transaction. Securities and Exchange Commission regulations also require additional disclosure in connection with any trades involving a "penny stock," including the delivery, prior to any penny stock transaction, of a disclosure schedule explaining the penny stock market and its associated risks. These requirements severely limit the liquidity of securities in the secondary market because few broker or dealers are likely to undertake these compliance activities. In addition to the applicability of the penny stock rules, other risks associated with trading in penny stocks could also be price fluctuations and the lack of a liquid market. If the selling security holders all elect to sell their shares of our common stock at the same time, the market price of our shares may decrease. It is possible that the selling security holders will offer all of the shares for sale. Further, because it is possible that a significant number of shares could be sold at the same time hereunder, the sales, or the possibility thereof, may have a depressive effect on the market price of our common stock. The exercise of outstanding warrants will be dilutive to our existing stockholders. At March 9, 2009 we had 15,262,035 shares of our common stock issued and outstanding and have reserved 2,629,431 shares for issuance upon the exercise of outstanding warrants to purchase common stock. The exercise of the warrants may materially adversely affect the market price of our common stock and will have a dilutive effect on our existing stockholders. Our outstanding warrants contain cashless exercise provisions as a result of which we will not receive any cash proceeds upon their exercise. Our outstanding common stock purchase warrants permit the holders to exercise their warrants by means of a cashless exercise. At any time after the required effective date of the registration statement the warrants are exercisable on a cashless basis if on the exercise date the shares of common stock issuable upon the exercise of the warrants are not covered by an effective registration statement. This means that the holders, rather than paying the exercise price in cash, may surrender a number of warrants equal to the exercise price of the warrants being exercised. The utilization of this cashless exercise feature will deprive us of additional capital which might otherwise be obtained if the warrants did not contain a cashless feature. The elimination of monetary liability against our directors, officers and employees under our certificate of incorporation and the existence of indemnification rights to our directors, officers and employees may result in substantial expenditures by our Company and may discourage lawsuits against our directors, officers and employees. Our certificate of incorporation contains provisions which eliminate the liability of our directors for monetary damages to our Company and stockholders to the maximum extent permitted under Delaware corporate law. Our By-laws also require us to indemnify our directors to the maximum extent permitted by Delaware corporate law. We may also have contractual indemnification obligations under our agreements with our directors, officers and employees. The foregoing indemnification obligations could result in our Company incurring substantial expenditures to cover the cost of settlement or damage awards against directors, officers and employees, which we may be unable to recoup. These provisions and resultant costs may also discourage our Company from bringing a lawsuit against directors, officers and employees for breaches of their fiduciary duties, and may similarly discourage the filing of derivative litigation by our stockholders against our directors, officers and employees even though such actions, if successful, might otherwise benefit our Company and stockholders. CAUTIONARY